credit analysis Flashcards
Flashcard 1: ROE Disaggregation - DuPont Analysis
Q: What is the DuPont Analysis formula for ROE?
A: ROE = Profit Margin × Asset Turnover × Financial Leverage
Flashcard 2: Alternative ROE Disaggregation
Q: What is an alternative way to disaggregate ROE?
A: ROE = Operating ROA + Net Financial Leverage × (Operating ROA – Borrowing Cost)
Flashcard 3: Financial Leverage
Q: How does financial leverage impact performance?
A: Leverage amplifies performance, making good times better and bad times worse.
Flashcard 4: Forward-Looking Element of Leverage
Q: Why is financial leverage forward-looking?
A: Levered firms commit to future payments, which impact their financial flexibility.
Flashcard 5: Credit Risk
Q: What is credit risk?
A: The likelihood of defaulting on amounts owed to creditors.
Flashcard 6: Why Shareholders Care About Credit Risk
Q: Why should shareholders be concerned about credit risk?
A: High credit risk leads to higher borrowing costs and increases the threat of liquidation.
Flashcard 7: Short-Term Liquidity Risk
Q: What is short-term liquidity?
A: A firm’s ability to generate sufficient cash to supply working capital needs and service short-term obligations.
Flashcard 8: Causes of Short-Term Liquidity Problems
Q: What can cause short-term liquidity issues?
A: Timing mismatches or excessive leverage.
Flashcard 9: Long-Term Solvency Risk
Q: What is long-term solvency?
A: A firm’s ability to meet long-term debts and financial commitments.
Flashcard 10: Causes of Long-Term Solvency Problems
Q: What can lead to long-term solvency issues?
A: Persistent losses or excessive leverage.
Flashcard 11: Exposure to Superstar Firms and Financial Distress
Q: How can exposure to superstar firms impact bankruptcy risk?
A: Even in booming industries, exposure to superstars increases a firm’s bankruptcy risk (Cheng et al., 2024).
Flashcard 12: Liquidity & Solvency Connection
Q: How are liquidity and solvency related?
A: Liquidity issues can be early symptoms of solvency problems; illiquidity can lead to insolvency.
Flashcard 13: Short-Term Liquidity Ratios
Q: What are two key short-term liquidity ratios?
A:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid-Test Ratio) = (Cash + Marketable Securities + Receivables) / Current Liabilities
Flashcard 14: Drawbacks of Liquidity Ratios
Q: What are potential issues with liquidity ratios?
A: Not all current assets convert to cash quickly; subject to management manipulation.
Flashcard 15: Long-Term Solvency Ratios
Q: What are two key long-term solvency ratios?
A:
Liabilities to Assets Ratio = Total Liabilities / Total Assets
Liabilities to Shareholders’ Equity Ratio = Total Liabilities / Total Shareholders’ Equity
Flashcard 16: Drawbacks of Solvency Ratios
Q: What is a limitation of solvency ratios?
A: They blend interest-bearing and non-interest-bearing liabilities, which may obscure risk assessment.
Flashcard 17: Debt Ratios for Solvency Analysis
Q: How do we separate interest-bearing from non-interest-bearing liabilities?
Total Debt to Shareholders’ Equity Ratio = (Long-Term Debt + Short-Term Debt) / Total Shareholders’ Equity
Long-Term Debt to Long-Term Capital Ratio = Long-Term Debt / (Long-Term Debt + Total Shareholders’ Equity)
Long-Term Debt to Shareholders’ Equity Ratio = Long-Term Debt / Total Shareholders’ Equity
Flashcard 18: How to Use B/S Accounts in Credit Ratios
Q: What is the best practice for using balance sheet accounts in credit ratios?
A: Use the ending balance as it is most relevant for assessing future credit risk.
Flashcard 19: Drawback of Traditional Credit Ratios
Q: What is the major drawback of credit ratios?
A: They focus on stock variables and ignore flow variables.
Flashcard 20: Coverage Ratios for Solvency Analysis
Q: What are coverage ratios and why are they important?
A: Coverage ratios assess a firm’s ability to generate cash to cover debt obligations.
Flashcard 21: Key Coverage Ratios
Q: What are four commonly used coverage ratios?
A:
Times Interest Earned
EBITDA Coverage Ratio
Cash from Operations to Total Debt
Free Operating Cash Flow to Total Debt
Flashcard 22: Times Interest Earned Ratio
Q: What does the times interest earned ratio indicate?
A: Reflects operating income available to pay interest expense, assuming principal refinancing.
Flashcard 23: Key Considerations for Times Interest Earned Ratio
Q: What should be used for numerator and denominator in this ratio?
A:
Numerator: Operating Income vs. EBIT (Pre-tax Income + Interest Expense)
Denominator: Raw Interest Expense vs. Net Interest Expense (Interest Expense – Interest Income)
Flashcard 24: EBITDA Coverage Ratio
Q: Why is EBITDA coverage ratio widely used?
A: It excludes depreciation, a non-cash expense, making it a more relevant liquidity measure.
Flashcard 25: Cash Flow to Total Debt Ratio
Q: What does the cash flow to total debt ratio measure?
A: A company’s ability to generate cash flow to cover debt payments.
Flashcard 26: Additional Topics in Credit Risk Analysis
Q: What are additional tools for credit risk evaluation?
A:
Credit rating analysis
Bankruptcy prediction models like Altman’s Z-score and Ohlson’s O-score
Flashcard 28: Convertible Notes in Tesla’s Debt
Q: How do convertible notes impact financial structure?
A: They offer a lower interest rate compared to bonds, delay equity dilution, and eliminate principal payments upon conversion.
Flashcard 29: Key Takeaways on Liquidity and Solvency
Q: What are the key insights for evaluating liquidity and solvency?
A:
Short-term liquidity risk: cash availability (current & quick ratios)
Long-term solvency risk: debt level (coverage ratios)
Alternative ROE disaggregation for leverage analysis
Liquidity impacts solvency and borrowing costs
