This lesson examines the systems used to identify deteriorating credit quality before it becomes a default, including the classification of Special Mention Accounts (SMAs).

5.1 The Purpose of Early Warning Systems (EWS)

Early Warning Systems are frameworks for identifying potential credit problems before they escalate into defaults . The goal is to enable timely intervention to prevent losses and avoid the need for costly recovery actions. Training programmes now emphasise “how to use early credit default warning indicators to reduce cases of default” .

5.2 Categories of Early Warning Indicators

The International Finance Corporation (IFC) identifies several key categories of early warning signals :

  • Operating EWS: Declining sales, loss of key customers, production problems.

  • Business EWS: Weakening market position, loss of competitive advantage.

  • Financial EWS: Deteriorating liquidity, rising debt levels, declining profitability.

  • Investment EWS: Over-expansion, poor investment decisions.

  • Reporting EWS: Delayed financial statements, irregular reporting, communication breakdown.

5.3 Special Mention Accounts (SMA) Classification

SMAs are accounts showing early signs of distress but not yet classified as Non-Performing Assets . The classification typically includes:

  • SMA-0: Accounts with payment overdue for 1-30 days.

  • SMA-1: Accounts with payment overdue for 31-60 days.

  • SMA-2: Accounts with payment overdue for 61-90 days.

The liquidity crisis is often the final stage of a company’s collapse, with poor working capital management being a key driver . Early identification of SMAs allows for proactive intervention.

5.4 Applying Quantitative Models

Several quantitative models are used to predict failure:

  • Z-Score: A statistical model using financial ratios to predict bankruptcy risk .

  • GNPESTEL Model: A framework for analysing external risks including political, economic, social, technological, environmental, and legal factors .

  • Working Capital Analysis: Assessing management’s planning for working capital to identify overtrading and other risks .

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