All Terminology Flashcards
What Are The 5 Cs of Credit Analysis?
Character, Capacity, Capital, Collateral, Conditions
What is Capital?
Money or credit used to build wealth
Character (5Cs)
Who the person is; are they trustworthy, why they are taking the project, are there any negative affiliations with the person? (Credit history)
Capacity (5Cs)
Measures the borrower’s ability to repay the loan by comparing income against recurring debts (DTI ratio)
Capital (5Cs)
How much of the borrower’s own money are they putting into the project. Larger contributions decrease chance of defaulting
Collateral (5Cs)
What is securing the loan; this is what the lender can repossess if the borrower defaults.
Conditions (5Cs)
Length of time, industry performance, future job stability; adds risk consideration for future industry uncertainty.
What does TCM stand for?
Treasury Constant Maturity
What is TCM?
An index by the Federal Reserve Board based on the average yield of a range of Treasury securities (adjusted to a five-year maturity)
Amortized Loan Schedule
A loan with scheduled, periodic payments that are applied to the principal and accrued interest.
How are regular amortized loan payments applied?
First to the interest balance then the remaining pays down the principal
When are regular payment amounts on a fully amortizing loan changed?
Never, the payments will be the same for the life of the loan, the only change will be how much goes to interest vs principle
Rate Floor
Used in adjustable-rate mortgages, this is the minimum interest rate a loan can have in the life of the loan.
Why do lenders include a rate floor in ARMs?
To cover costs associated with processing and servicing the loan, as it prevents interest rates from adjusting below a preset minimum
Term
The length of time you commit to the rate, lender, and associated terms and conditions
What happens when a term is up but the loan is not fully paid off?
You must renew your mortgage on the remaining principal at a new rate available at the end of the term
Maturity vs Amortization
Maturity is the date when full payment is due, whereas amortization is the reduction of loan principal over a series of payments
bps
Basis points (1/100th of a percent)
Yield Maintenance (YM)
Prepayment penalty that allows investors to attain the same yield as if the borrower made all scheduled interest payments up until the maturity date
Yield Maintenance formula
YM = (Present Value of Remaining Payments) * (Interest Rate - Treasury Yield)
Present Value
The current value of a future sum of money (or stream of cash flows) at a specified rate of return
Discount rate
Expresses the time value of money, helps determine whether an investment project is financially viable
Discounted Cash Flow (DCF)
Estimates the value of an investment based on its expected future cash flows
What is typically used for the discount rate in DCF analysis? Why?
Weighted average cost of capital (WACC) because it accounts for the rate of return expected by shareholders
Discounted Cash Flow Formula
Sum of cash flow years where each year is equal to (CFy)/((1+r)^y) where CFy = cash flow for that project year y, r = the discount rate, and y equals the project year
Weighted Average Cost of Capital
Average rate of return that shareholders in the firm are expecting for a given year
What does a positive number from an NPV calculation indicate?
The project could generate a higher return than the initial cost
What’s the difference between DCF and NPV?
Net present value adds a fourth step to DCF, which is subtracting the cost of the initial investment
DCF calculation steps
(1) Forecasting expected cash flows, (2) selecting a discount rate, (3) discounting the cash flows and totaling them.
Indemnity
Comprehensive form of compensation for damage or loss
Prepayment penalty (indemnity)
Typically applied only when refinancing, selling, or paying off large amounts of a loan, they are used to protect the lender from financial loss (through significantly lower total interest payments).
Step-Down prepayment penalty
Gradually declining penalty over the term of the loan, which is a percentage of the outstanding loan balance (decreases)
5-4-3-2-1 prepayment indemnity
In a five-year loan, the prepayment penalty will be 5% if paid in year one, 4% if in year two, and so on.
Profitability Ratios
Ratios that measure the ability of the company to generate a profit relative to revenue, assets, and shareholder’s equity. Can be split into margin ratios and return ratios
EBITDA
Earnings before Interest, Taxes, Depreciation, and Amortization
EBITDA Margin
Profitability ratio that measures how much in earnings a company is generating before interest, taxes, depreciation, and amortization as a percentage of revenue
Gross Profit
Sales Revenue minus COGS
Gross Margin
Gross Profit/Total Revenue (x100 to get percent)
Operating Profit
AKA EBIT, it is the revenue after COGS and operating expenses (including depreciation and amortization)
Operating Profit Margin formula (using Income Statement, simple and expanded)
Simple: OPM = Operating Profit/Revenue Expanded: OPM = (Revenue - COGS - Operating Expenses) / Revenue
What is the key difference between Operating Profit Margin and Net Profit Margin?
OPM is a measure of a company’s ability to be profitable, as it focuses solely on operations through exclusion of interest and taxes. NPM includes interest and taxes
Return on Assets
Shows how productive and efficient management is in utilizing economic resources by dividing Net Income by Assets (either average or end of period)
Return on Equity
Shows the firm’s ability to turn equity into profits by dividing net income by shareholder’s equity
What do high margin and return (profitability) ratios indicate?
The company has a greater ability to pay back debts in incurs.
Leverage Ratios
Compare the level of debt against other accounts on financial statements, helping CAs gauge the ability of businesses to repay their debts (D-A, A-E, D-E, D-C ratios)
Debt to Assets Ratio
Used to understand the degree to which a company’s operations are funded by debt. D-A = Total funded debt / total assets
What do lower leverage ratios indicate?
Less existing risk
Debt to Equity Ratio
Liability ratio that calculates the weight of total debt and financial responsibilities against total shareholder’s equity (how many cents/dollars are leveraged for every dollar of equity)
Coverage Ratios
Measure the coverage that income, cash, or assets provide for debt or interest expenses
Interest Coverage Ratio
EBIT / Interest Expenses. AKA the ‘times interest earned,’ it shows how many times the company could pay the interest expense for a given period
Debt Service Coverage Ratio
Credit metric used to understand how easily operating cash flow can cover annual interest and principal obligations. DSCR = (Cash Flow +/- Adjustments) / (Interest + Principal). Typically numerator is EBITDA - Cash Taxes (proportion of total income tax due in cash during the measurement period)
Liquidity Ratios
Indicate the ability of a company to convert assets into cash
Current Ratio
Current Assets / Current Liabilities
Quick Ratio
Measures ability to pay liabilities using the most liquid assets. QR = (Cash & equivalents + marketable securities + accounts receivable) / Current liabilities
Cash Ratio
Ratio used to show a company’s ability to pay off short-term debt with cash and cash equivalents. CR = (Cash & equivalents) / Liabilities
Working Capital
Shows the short-term liquid assets available after short-term liabilities have been paid off. WC = Current Assets - Current Liabilities
4 Groups of Key Ratios
Profitability, Leverage, Coverage, and Liquidity
What do you want to accomplish in your role as a credit analyst?
I want to grow my base knowledge of how businesses operate by analyzing companies, watching them grow through the use of debt, and gaining more insight into different industries. I want to put my analytical mindset and love for statistics to the test and be able to use them to learn every day.
How will you ensure you don’t make mistakes in your work?
I always double or triple-check my work, and if I am not confident of the answer to something or my understanding of why something is the way it is, I will research further and ask questions of those with experience until I understand and can confidently explain it. I know that as a credit analyst mistakes can be extremely costly so it is very important to me that I do not submit or claim something without having a full understanding of the ‘why.’
Describe a time when you felt pressure at work. How did you handle that?
One Friday in the branch we had two people on vacation that day and one person out sick, which left us with only three people in cash on teller row. It was around 3:00 and I had just received around 12 deposits through courier, night drop, and a walk-in client that totaled a little over $70,000 cash. I had to run all of it separately to verify the deposits, sort it all, and then strap and stamp it by 3:45. But with how short we were and it being a Friday, we had so many clients coming in that I couldn’t start right away. I took it one client at a time and stepped into the vault when I could, and came back out when both of the other tellers were with a different client and another one came in. It was stressful and a time crunch, but by taking it one client and one deposit at a time, everything was able to be taken care of in a timely manner. By not panicking, everything was done correctly and no client had more than a minute wait before being helped.
Describe a time when you had to deal with an angry or upset client or colleague.
A couple of months ago a client who doesn’t come into the branch came in wanting to withdraw cash from his account. I asked for his ID because I didn’t recognize him, but he said he didn’t have it with him because he forgot his wallet at home, and got upset and sarcastic. He asked for Rachael and Jenny, saying they could ID him, but Rachael was out and Jenny was in a board meeting. He tried to rush me, saying he wouldn’t tell anyone and that he had an important meeting in ten minutes so needed the cash. I did not give in and stayed calm. I decided to treat the situation as if he was calling in and verified him using ‘Know Your Client’ guideline questions, which he was able to answer correctly, with a little sarcastic pushback. I also matched his signature to the sig card in Navigator for a third check. He came back the next day and thanked me, apologized for being snippy, and talked to Rachael about how impressed he was by the interaction.
How is the interest coverage ratio calculated?
EBIT divided by interest balance for the given period
SG&A
Selling, General, and Administrative Expenses (expenses not assigned to a specific product)
What is the key difference between EBIT and operating income?
EBIT includes non-operating income, non-operating expenses, and other income
Imagine there is a prospective client, a big name in the business, asking for a long-term loan. Your analysis shows that they might struggle with repaying the credit. What would you do in this case?
It depends on the extent to which the analysis shows they would struggle and the amount of potential other business they would likely bring in. If they have the pull that banking with us could bring in large deposit accounts and other prospective loans, it may be worth taking on the slightly higher risk of default.
How do you determine whether you should lend money to a company?
The first step is digging into the company’s finances from previous years. Identifying the amount of cash flow, what assets could be used as collateral, and the trends of the business year-over-year. Using those to determine the 5 Cs: character, capital, collateral, capacity, and conditions, allow for considering qualitative and quantitative factors. These can be compared to Summit’s parameters for lending to determine if we should lend the money.
How proficient are you with financial software and technology?
I am well-versed in Excel, as shown by being responsible for many of the spreadsheets used in the branch. I am also very familiar with interest calculators through my personal investment planning research. I do not have much experience with financial software such as nCino, but I am highly motivated by being able to learn new skills and ways to perform calculations, so learning how to use it will not be a problem.
Which financial statement will allow you to determine the gross margin?
Income statement
What does the heading of a balance sheet indicate?
A point in time (not a period)
A corporation’s net income will cause a change in which component of shareholders’ equity?
Retained Earnings
What amounts are used to calculate a company’s working capital?
Current assets and current liabilities
What is a reasonable Debt-to-Capital ratio?
It depends on the industry. Some can sustain low debt-to-capital ratios, like startups, whereas banking and insurance can have up to 90%, where the majority of capital used comes from deposits that the bank must pay interest on
Debt-to-Capital Ratio
Measurement of financial leverage that divides interest-bearing debt by total capital
What do credit rating agencies do?
Rating agencies help provide trust and confidence by rating borrowers on their creditworthiness of outstanding debt obligations. However, there can be conflicts of interest involved so cannot be blindly relied on.
What is Free Cash Flow?
Free Cash Flow is the amount of cash flow for discretionary spending by management and/or shareholders. It is found on the cash flow statement by taking the cash from operations and subtracting cash from investing (capital expenditures)
What methods do you use to compare the liquidity, profitability, and credit history of a company?
Current Ratio (L), Quick Ratio (L), Return on Equity (P), Return on Assets (P), Debt/Capital (CH), Debt/Equity (CH), and Interest Coverage (CH)
What are the most common credit metrics banks look at?
Debt/equity, debt/capital, debt/EBITDA, interest coverage, and tangible net worth
Tangible Net Worth
Refers to the company’s net worth that includes only tangible assets after deducting liabilities and intangible assets. TNW = Total Assets - Total Liabilities - Intangible Assets
Intangible assets
Assets that are not touchable/do not physically exist such as patents, copyrights, IP, goodwill, etc.
How do you value a company?
The most common methods are DCF Valuation and relative valuation methods using comparative public companies and precedent transactions
DCF Valuation
Discounted Cash Flow model used to determine the value of a business using expected future cash flows
What do you use for the discount rate in a DCF Valuation?
Weighted Average Cost of Capital (WACC)
Terminal Value
The value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated (usually 3-5 years). Assumes a business will grow at a set growth rate forever after the forecast period. Once calculated this is then discounted back using WACC
How is Terminal Value calculated in a DCF Valuation?
Using an exit multiple or the perpetual growth method
Exit multiple (TV calculation)
Uses a market multiple basis to fairly value a business by multiplying financial metrics (like EBIT or EBITDA) by a factor obtained from comparable companies that were recently acquired
Perpetual growth method (TV calculation)
Accounts for free cash flows of a business that grow at a steady rate in perpetuity. Assumes cash will grow at a stable rate forever, starting at a specific point in the future. The growth rate is based on the historical performance of the company.
What type of person makes a good credit analyst?
A numbers person with an analytical mindset and a positive attitude, who works well in a team, and is willing to learn. Strong communication skills and financial intuition are also important.
How do you manage risk in your life?
The main thing I do to manage risk in my life is to only say things that I believe are true and that I feel I can justify what I said and why I said it. When making decisions, I do not like to go on impulse, rather I consider potential consequences and gains of different options and only make a decision once I can justify a ‘why’ with knowledge of potential consequences. To me, the best way of managing risk is by understanding and acknowledging it.
Weighted Average Cost of Capital formula
Cost of Equity * (% equity) + Cost of Debt * (% debt) * (1 - Tax Rate) + Cost of Preferred Stock * (% preferred stock)
