Chapter 7: Risks and Credit Risk Management Flashcards by Emil Melchor

refers to the potential loss that a lender or investor may incur due to the failure of a borrower to repay a loan or meet their financial obligations as agreed upon.

a. Credit Risk
b. Insolvency Risk
c. Liquidity Risk

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It encompasses the probability of default by the borrower and the potential loss that the lender may face as a result.

A. Insolvency Risk
B. Liquidity Risk
C. Credit Risk

C. Credit Risk

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is the risk that an entity may not be able to quickly sell its assets or obtain funding at a fair price to meet its short-term obligations or financial needs, potentially leading to financial losses or operational disruptions.

a. Interest Rate Risk
b. Liquidity Risk
c. Credit Risk

b. Liquidity Risk

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is the risk that the value of an investment will decline due to changes in interest rates.

a. Interest Rate Risk
b. Market Risk
c. Credit Risk

a. Interest Rate Risk

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This risk affects fixed-income securities, such as bonds, where fluctuations in inter est rates can impact their market prices and yields.

a. Insolvency Risk
b. Off-balance sheet risk
c. Interest rate risk

c. Interest rate risk

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also known as systematic risk, is the risk of losses in investments due to factors such as changes in market prices, interest rates, currency exchange rates, or other external factors that affect the overall market.

a. Technology risk
b. Market Risk
c. Solvency Risk

b. Market Risk

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It encompasses the uncertainty of returns caused by macroeconomic and geopolitical events that impact the entire market.

a. Market Risk
b. Off-balance sheet risk
c. Foreign Exchange Risk

a. Market Risk

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refers to potential losses that a company may face from financial instruments or commitments that are not recorded on its balance sheet but still have the potential to affect its financial health.

a. Technology risk
b. Foreign Exchange risk
c. Off-balance sheet risk

c. Off-balance sheet risk

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These include items such as contingent liabilities, guarantees, or off-balance-sheet financing arrangements, which may expose the company to financial obligations or losses not immediately apparent in its financial statements.

a. Off-balance sheet risk
b. Credit Risk
c. Market Risk

a. Off-balance sheet risk

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also known as currency risk, is the risk that fluctuations in exchange rates will adversely affect the value of investments denominated in foreign currencies.

a. Market Risk
b. Off-balance sheet risk
c. Foreign Exchange Risk

c. Foreign Exchange Risk

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It arises when a company or investor holds assets, liabilities, or operates in currencies other than their domestic currency, potentially leading to losses due to adverse movements in exchange rates.

a. Credit Risk
b. Foreign Excahange risk
c. Interest rate risk

b. Foreign Excahange risk

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refers to the risk associated with investing in or lending to a specific country, stemming from factors such as political instability, economic volatility, regulatory changes, and potential for default on sovereign debt obligations.

a. Country or sovereign risk
b. foreign exchange risk
c. Interest rate risk

a. Country or sovereign risk

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This risk can impact the financial performance of investments or loans tied to the economic well-being and stability of a particular nation.

A. Market Risk
B. Foreign Exchange risk
C. Country or sovereign risk

C. Country or sovereign risk

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refers to the potential for adverse impacts on an organization’s operations, finances, or reputation resulting from failures, disruptions, or inadequacies in technology systems, infrastructure, or processes.

a. Solvency Risk
b. Technology Risk
c. Operational Risk

b. Technology Risk

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This risk encompasses a wide range of issues, including cybersecurity threats, system failures, data breaches, technological obsolescence, and challenges in adapting to new technologies.

a. Operational Risk
b. Market Risk
c. Technology Risk

c. Technology Risk

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refers to the risk of losses resulting from inadequate or failed internal processes, people, systems, or external events.

a. Operational Risk
b. Insolvency Risk
c. Liquidity Risk

a. Operational Risk

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It encompasses a wide range of factors, including human error, system failures, fraud, legal and regulatory compliance issues, and disruptions in business operations.

a. Insolvency Risk
b. Operational Risk
c. Technology Risk

b. Operational Risk

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refers to the likelihood that an individual or entity will become unable to meet its financial obligations and repay its debts as they become due.

a. Insolvency Risk
b. Market Risk
c. Credit Risk

a. Insolvency Risk

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This risk indicates the potential for financial distress or bankruptcy due to insufficient liquidity, declining cash flows, or excessive debt burdens.

a. Operational Risk
b. Insolvency risk
c. Liquidity Risk

b. Insolvency risk

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refers to the process of identifying, assessing, and managing the risks associated with lending money to individuals, businesses, or other entities.

Credit Risk management

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Formula of Gross Debt service Ratio

Gross Debt Service ratio (GDS)

GDS = Annual mortgage payments + Property taxes
/ Annual Gross Income

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Formula of Total Debt Service Ratio

TDS = Annual total debt payments
/ Annual Gross Income

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Two Ratios in Credit Analysis

Gross Debt Service Ratio
Total Debt Service Ratio

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True or False

FI consider an applicant the GDS and TDS ratio is less than an acceptable threshold.

True

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The threshold is commonly _______________ for the GDS ratio and _________________ for the TDS ratio.

25 to 30 percent; 35 to 40 percent

A mathematical model that uses observed characteristics of the loan applicant to calculate a score that represents the applicant’s probability of default.

Credit Scoring System

In credit scoring system, if applicant’s total score: < 120 = ? > 190 = ? 120 - 190 = ?

< 120 = Reject > 190 = Accept 120 - 190 = reviewed by a loan committee for a final decision

are those businesses with pre taxed earnings between $5 million to $250 million

Middle Market Companies

have a recognizable corporate structure unlike many small businesses but do not have ready access to deep and liquid capital markets.

Middle Market Companies

a term used to describe the flexible financing options the Middle Market Companies have at their disposal to take their businesses to the next level.

Industrial Lending

Two Sub-Categories of Middle Market Companies

1. Lower Middle Market 2. Upper Middle Market

are those companies with revenues slightly greater than small and medium-sized enterprises (SMEs)

Lower Middle Market Companies

are those companies that net annual revenues between $500 to $ 1 Billion

Upper Middle Market Companies

5'Cs of Credit

character capacity collateral condition capital

is a key tool for managing credit risk on the balance sheet.

Ratio Analysis

By calculating specific ratios, you can assess a borrower's ability to repay debt and make informed lending decisions.

Ratio Analysis

are important tools lenders use to assess a loan applicant's ability to meet short-term financial obligations. a. Liquidity Ratios b. Efficiency Ratio c. Leverage Ratio

Liquidity ratios

They don't directly measure an applicant's creditworthiness, but rather their capacity to handle upcoming debt payments. a. Profitability Ratio b. Efficiencey Ratio c. Liquidity Ratio

c. Liquidity Ratio

This is the most common liquidity ratio. It compares a company's or individual's current assets to their current liabilities.

Current Ratio

This is a more conservative measure of liquidity that excludes inventory from current assets

Quick Ratio

Formula of Current Ratio

Current Assets / Current Liabilities

Formula of Quick Ratio

(Current Assets - Inventory) / Current Liabilities

also known as Asset management ratios , are financial metrics used to assess a company's ability to generate revenue from its assets a. Liquidity Ratio b. Profitability Ratio c. Efficiency Ratio

c. Efficiency Ratio

Measures the average time it takes a company to collect payment from customers after a sale is made on credit

Number of Days Sales in Receivables (DSO)

Measures the average time it takes a company to sell and replace its inventory.

Number of Days in Inventory (DOH)

Formula of Days in Inventory (DOH)

( Inventory / Cost of Goods Sold) x 365 days

Formula of Number of Days Sales in Receivables (DSO)

Accounts Receivable / Net Credit Sales) x 365 days

Measures the efficiency of a company's use of working capital (funds used for day-to-day operations) to generate sales

Sales to Working Capital

Formula of Sales to Working Capital

Formula: Net Sales / Working Capital

Measures the amount of sales generated per dollar invested in fixed assets (long-term assets like property, plant, and equipment).

Sales to Fixed Assets (Fixed Asset Turnover)

Formula of Sales to Fixed Assets (Fixed Asset Turnover)

Formula: Net Sales / Fixed Assets

Measures the overall efficiency of a company's use of all its assets to generate sales.

Sales to Total Assets (Asset Turnover)

Formula of Sales to Total Assets (Asset Turnover)

Formula: Net Sales / Total Assets

also known as leverage ratio are the basis of analyzing credit risk on a company's balance sheet. They provide insight into a borrower's ability to meet both short-term and long-term financial obligations.

Debt & Solvency Ratio

These ratios measure the amount of debt a company has compared to its equity or assets. It is the ratio of total debt and total assets.

Debt Ratios

These ratios take a broader view, assessing a company's ability to survive in the long term and meet all its financial commitments.

Solvency Ratios

Measures the proportion of a company's assets that are financed by debt (loans and other liabilities).

Debt-to-Asset Ratio

Formula of Debt-to-Asset Ratio

Formula: Total Liabilities / Total Assets

Measures a company's ability to cover its interest expenses on outstanding debt

Times Interest Earned Ratio (TIE Ratio)

Formula of Times Interest Earned Ratio (TIE Ratio)

Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense

Measures a company's ability to service its debt obligations using its operating cash flow (the cash generated from its core business activities)

Cash Flow to Debt Ratio

Formula of Cash Flow to Debt Ratio

Formula: Cash Flow from Operations + Depreciation / Total Debt

Evaluate how effectively a company generates profits. A consistently strong ________________ suggests a borrower's potential to make loan payments, reducing credit risk

profitability ratio

Measures the percentage of each sales dollar remaining after accounting for the cost of goods sold (COGS).

Gross Profit Margin Ratio

Formula of Gross Profit Margin Ratio

Formula: Gross Profit / Net Sales x 100%

Measures the percentage of each sales dollar remaining after accounting for COGS, selling, general & administrative expenses (SG&A).

Operating Profit Margin Ratio

Formula of Operating Profit Margin Ratio

Formula: Operating Income / Net Sales x 100%

Measures how effectively a company uses its assets to generate profit

Return on Assets (ROA) Ratio

Formula of Return on Assets (ROA) Ratio

Formula: Net Income / Total Assets x 100%

Measures how much profit a company generates relative to the shareholders' investment in the company

Return on Equity (ROE) Ratio

Formula of Return on Equity (ROE) Ratio

Formula: Net Income / Shareholders' Equity x 100%

Measures the percentage of a company's net income that is paid out to shareholders as dividends

Dividend Payout Ratio

Formula of Dividend Payout Ratio

Formula: Dividends Paid / Net Income x 100%

Cautions with ratio analysis

- Different Accounting Practices - Inflationary Effects - Historical Information - Ignores Qualitative Factor - Operating in Multiple Industries

is a tool that financial managers use to assess the relative proportions of different financial statement items.

Vertical analysis

It evaluates financial statements by expressing each line item as a percentage of a base amount for that period.

Vertical Analysis

is given to a business for commercial or industrial purposes. These loans provide funding for qualified business expenses, including working capital.

commercial and industrial (C&I) loan

are an important form of external financing, as they allow large companies to obtain funds for various projects.

Commercial and industrial loans

The indicator variable Z is an overall measure of the borrower’s default risk classification.

Altman's z score

This classification, in turn, depends on the values of various financial ratios of the borrower (Xj) and the weighted importance of these ratios based on the observed experience of defaulting versus non defaulting borrowers derived from a discriminant analysis model.

Altman's z score

Formula of Altman's z score

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Formula of Altman's z score (X1)

X1 = Working Capital / Total Assets

Formula of Altman's z score (X2)

X2 = Retained Earnings / total assets

Formula of Altman's z score (X3)

X3 = earnings before interest and taxes / total assets

Formula of Altman's z score (X4)

X4 = market value of equity / book value of total liabilities

Formula of Altman's z score (X5)

X5 = sales / total assets

In Altman's z score Less than 1.81 – ? Between 1.81 and 2.99 – ? Greater than 2.99 – ?

Less than 1.81 – high default risk firm Between 1.81 and 2.99 – intermediate default risk firm Greater than 2.99 – low default risk firm

is a tool used to assess and track the credit risk of borrowers over time. It employs various quantitative techniques and data analysis methods to evaluate the financial health and repayment capacity of borrowers.

Moody's Analytics credit monitoring model

The model continuously monitors changes in key financial metrics, market conditions, and other relevant factors to provide timely insights into credit risk dynamics. helps financial institutions and investors make informed decisions about lending, investment, and risk management.

Moody's Analytics credit monitoring model

Formula of RAROC

RAROC= one year income on loan /Loan risk or value at risk or RAROC= one year income on loan / Value of a loan x unexpected default rate x loss given by default or RAROC= Revenue - costs - expected losses / Economic capital