Brainscape's Knowledge GenomeTM


Top Flashcards (Certified)
All Flashcards

AFM212 > week 3 | market for credit & credit analysis > Flashcards

week 3 | market for credit & credit analysis Flashcards

1
Q

what is the process of credit analysis & what does it involve

A

Process of evaluating the ability & willingness of a borrower (corporation, gov’t, individual) to meet their financial obligations, typically in the form of loans or bonds

Involves detailed assessment of the credit risk associated w/ lending money or extending credit to a borrower

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

primary purpose of credit analysis

A

Primary purpose: to determine the likelihood that a borrower will repay their debt on time & in full

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

what is credit risk

A

Credit risk → risk that a borrower will fail to meet financial obligations as come due, leading to a loss for lenders/investors

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

3

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

supplier of credit

A

Internal corporate credit terms
Bank’s in-house credit analysis teams
Credit rating agencies
- S&P
- Moody’s
- Fitch
Fixed-income research firms
Consulting firms

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Demand for Credit: Operating Activities

A
  • Companies have cyclical operating cash needs
    • Manufactures need cash for materials or labour
    • Advance seasonal purchases
  • Cash needed for operating activities is not uniformly “low risk”
    • Cash needed to cover operating losses might not be temporary
  • A willing lender could make the difference b/w bankruptcy & continued operations for a company
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Demand for Credit: Investing Activities

A

Companies require large amounts of cash for investing activities → purchase of property, plant & equipment or for corporate acquisitions
- New PP&E (CAPEX)
- Intangible assets
- Mergers & acquisition
- LBO (Leverage buyout)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Demand for Credit: Financing Activities

A

Companies occasionally need credit for financing activities
- A bank loan or bond matures
- Rolling loans
- Funds to repurchase stock

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Supple of Credit: Trade Credit

A
  • Trade (supplier) credit is routine & non-interest bearing
  • Suppliers’ credit terms specify
    • Amount & timing of any early payment discounts
    • Maximum credit limit
    • Payment terms
    • Other restrictions or specifications
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Supple of Credit: Bank Loans

A

Bank structure financing to meet specific client needs
- Revolving credit line (revolvers)
- Line of credit (back-up credit facilities)
- Term loans (“bank loans”)
- Mortgages

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Revolving credit line

A

Cash available for seasonal shortfalls
Bank commits to a credit line maximum, balance repaid later in the year
Low fees on unused balance, high fees on used balance

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Line of credit

A

Bank provides a guaranty that funds will be available when needed

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Term loans

A

Fund PP&E (collateral)
Loan duration matches useful life of PP&E

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Mortgage

A

Real estate transactions
Lender takes property as security

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

Supple of Credit: Other Forms of Financing

A
  • lease financing
  • publicly traded debt
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

lease financing

A

Leasing firms finance CAPEX
Leasing companies → publicly traded

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

publicly traded debt

A

Cost efficient way to raise large amounts of funding
Regulated by SEC
Commercial paper → matures w/in 270 days
Bonds & Debentures → longer terms, trade on major exchanges
Rated for credit quality

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Credit Risk Analysis Process

A

Purpose is to quantify potential credit losses so lending decisions are made with full info

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

expected credit loss is the product of which 2 factors?

A

change of default (debtor’s ability to repay debt) * loss given default (size of loss if debtor defaults)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

what is the purpose of knowing the chance of default?

A

Purpose is to quantify the risk of loss from non-payment

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

what does chance of default depend on?

A

Chance of default depends on company’s ability to repay its obligations → depends on future cash flow & profitability

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

4 steps to determine chance of default

A
  1. evaluate the nature & purpose of the loan
  2. assess macroeconomic environment & industry conditions
  3. perform financial analysis
  4. perform prospective analysis
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

what is the EDF model & who was it developed by?

A

Expected Default Frequency Model
- Estimates the profitability of a firm defaulting within a specified time horizon (~ one year)
- Developed by Moody’s Analytics → widely used in credit risk assessment by large financial institutions

24
Q

key components of EDF model

A
  • Market Value of Assets (V): estimated using the market value of equity & book value of liabilities
  • Default Point (D): threshold where liabilities > assets (calculated as short-term + half of long-term liabilities)
  • Distance to Default (DD): measure of how far the firm’s asset value is from the default point
25
distance to default (dd) formula
dd = (market value of firms' asset - default point) / volatility of firm's asset value
26
Relationship b/w DD to Probability of Default (Expected Default Frequency) [reverse s shape curve]
AA higher DD (right side) corresponds to a lower EDF probability → lower likelihood of default A lower DD (left side) corresponds to a higher EDF probability → higher likelihood of default When DD = 0 → probability of default is 50%
27
how does stock price decrease affect firms DD & EDF
Decrease market & asset value Likelihood of default goes up
28
how does firm paying down long term debt using cash affect firms DD & EDF
Go down! No debt! Market value of asset → go down
29
what is Loss Given Default (LGD)
The amount that could be lost if the company defaulted on its obligations - Potential loss depends on priority of the claim compared with all other existing claims - Companies must repay senior claims first - US Bankruptcy Code specifies the priority of other claims
30
what does default mean?
failure to make payments & violation of loan covenants
31
how to minimize potential loss (LGD factors)
Credit limits Collateral Repayment terms Covenants
32
Summary of Liquidity Order in US Bankruptcy (in order)
1. Administrative costs (legal fees, court costs, trustee fees) 2. Secured creditors (w/ claims backed by collateral) 3. Priority unsecured creditors (wages, benefits, & taxes) 4. Unsecured creditors (bondholder, suppliers, customers etc) 5. Subordinated debt holders 6. Preferred shareholders 7. Common shareholders
33
week-related financial information adjustment
- Retailers typically have a 53rd week every 4-5 years - Must make all affected IS numbers - Adjust sales & expense that vary proportionately w/ sales (COS & SG&A) - Multiply by 52/53 - Do not adjust other expenses measured annually (interest, depreciation, & gains/losses) - Adjust tax expense proportionately based on effective tax rates (tax expense/pre-tax income)
34
2 coverage ratios
times interest earned & ebitda coverage ratio
34
what is coverage analysis
Considers a company’s ability to generate additional cash to cover principal & interest payments when due - Called “flow” ratios → consist of CF & IS data
34
times interest earned formula
earnings before interest & tax (EBIT) / interest expense, gross
35
EBITDA coverage formula
[earnings before interest & tax (EBIT) + depreciation + amortization] / interest expense, gross
35
define times interest earned
Reflects the operating income available to pay interest expense Assumes only interest must be paid → principal will be refinanced How many times the company can cover its interest expense
36
define EBITDA coverage
Measures company’s ability to pay interest out of current profits Non-GAAP performance metric More widely used than TIE → depreciation & amortization doesn’t require cash outflow Always higher than TIE
37
cash flow ratios
Cash from operations to total debt & Free operating CF to total debt
38
Cash from operations to total debt definition & formula
Measures the ability to generate addition cash to cover debt payments as come due = cash from operations / (short term debt + long term debt)
39
Free OCF to total debt definition & formula
Considers excess operating cash flow after cash is spent on capital expenditures = (cash from operations - CAPEX) / (short term debt + long term debt)
40
define liquidity ratio & list 2
Cash availability → how much cash a company has & how much it can generate on short notice current ratio & quick ratio
41
current ratio formula
= current assets / current liabilities
42
quick ratio formula
= (cash + marketable securities + AR) / current liabilities
43
define solvency ratio & list 2
Company’s ability to meet its debt obligations Solvency is crucial → an insolvent company is a failed company liabilities-to-equity ratio & total debt to equity
44
liabilities-to-equity definition & formula
= total liabilities / stockholders' equity how reliant a company is on creditor financing compared w/ equity financing
45
total debt to equity definition & formula
= (long term debt including current portion + short term debt) / stockholders' equity distinguishes b/w operating creditors & debt obligations
46
what does credit rating analysts at agencies consider?
Consider macroeconomic, industry, & firm-specific information Assess chance of default & ultimate payment in the event of default Provide ratings on both debt issues & issuers Predict loan default w/ fair degree of accuracy
47
S&P credit rating methodology: business risk
Country risk Industry risk Competitive position Profitability/Peer group comparisons
48
S&P credit rating methodology: financial risk
Accounting Financial governance & policies/risk tolerance Cash flow adequacy Capital structure/asset protection Liquidity/short-term factors
49
Credit Rating Agency Reform Act
- Signed into law in 2006 - Establishes a registration system for credit rating agencies - Separation of rating activities from other business activities (consulting) - Improved transparency → mandate disclosure of rating methodologies, performance track records & conflict of interest - Created list of Nationally Recognized Statistical Ratings Organizations (NRSRO) - SEC has designated only 9 of nearly 100 agencies as NRSROs
50
Rating of Issuers vs Rating of Issue
The issuer’s credit rating addresses the issuer’s overall creditworthiness & usually applies to senior unsecured debt Issue rating refers to specific financial obligations & considers ranking in the capital structure (secured or subordinated) However, cross-default provisions → refers to events of default → non-payment of interest on one bond triggering default on all outstanding debt, may often suggest the same default probability for all issues
51
Bankruptcy Prediction Indicators
Assess a company’s bankruptcy risk at a point of time Altman’s Z Model used to predict bankruptcy risk
52
Z-Score Interpretation
Shown to reasonably predict bankruptcy accurately for up to 2 years 95% accuracy in Year 1 72% accuracy in Year 2
53

AFM212 (7 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2025 Bold Learning Solutions. Terms and Conditions