Credit Analysis and Demand-Supply Dynamics

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Questions and Answers

What is the primary purpose of Altman’s Z model?

To predict stock market fluctuations

To assess employee productivity

To evaluate company credit ratings

To predict bankruptcy risk (correct)

What is the accuracy of the Z-Score in predicting bankruptcy for the first year?

90%

85%

75%

95% (correct)

Which formula component is multiplied by 0.99 in Altman's Z-Score calculation?

Sales (correct)

EBIT

Market Value of Equity

Retained Earnings

What does a Z-Score greater than 3.00 indicate about a company like Home Depot?

Healthy financial status Signup and view all the answers

Which element does NOT directly factor into the calculation of the Z-Score?

Current Ratio Signup and view all the answers

What does a credit analyst primarily assess when determining a credit rating?

Chance of default and payment abilities Signup and view all the answers

Which ratio is NOT commonly used by S&P to assess financial risk?

Cost of Capital Signup and view all the answers

What is the anchor credit rating for an issuer with a strong business risk profile and the given metrics?

BBB Signup and view all the answers

In the context of credit ratings, what does the FFO/DEBT ratio indicate?

Cash flow relative to the debt level Signup and view all the answers

Which step is least likely part of Moody's credit rating process?

Acknowledge regulatory issues Signup and view all the answers

What financial leverage ratio is used to evaluate company's debt levels?

Debt to capital ratio Signup and view all the answers

Which agency's methodology is referenced for providing a composite rating like bbb+?

S&P Global Ratings Signup and view all the answers

What might affect the final credit rating aside from the baseline credit rating?

Historical performance of the issuer Signup and view all the answers

What is the primary feature of a revolving credit line?

It commits a maximum credit line with repayment flexibility. Signup and view all the answers

Which financing option typically requires collateral tied to its useful life?

Term loans Signup and view all the answers

What characteristics define commercially traded debt?

Regulated by the SEC and can be traded on major exchanges. Signup and view all the answers

What is the main objective of credit risk analysis?

To quantify potential credit losses for informed lending decisions. Signup and view all the answers

The chance of default mainly relies on what factors?

Debtor's ability to repay and future cash flows. Signup and view all the answers

Which type of financing typically involves the lender taking property as security?

Mortgages Signup and view all the answers

What does expected credit loss represent in the context of lending?

The product of debtor's ability and potential loss magnitude. Signup and view all the answers

What financial tool is characterized by a commitment to provide funds when required?

Line of credit Signup and view all the answers

How does a decrease in stock price typically affect a firm's Distance to Default?

It decreases the Distance to Default. Signup and view all the answers

What is the effect of a firm refinancing short-term debt with long-term debt on its financial stability?

It typically improves financial stability. Signup and view all the answers

Which factor does NOT influence Loss Given Default (LGD)?

Stock price fluctuations. Signup and view all the answers

What priority do secured creditors hold under U.S. Bankruptcy Code?

First priority after administrative costs. Signup and view all the answers

If a firm increases its time horizon for debt repayment from 1 year to 2 years, how does this generally affect its risk?

It decreases the firm's risk of default. Signup and view all the answers

What defines the maximum amount that a creditor allows a customer to owe at any given time?

Credit limit. Signup and view all the answers

Which statement is true regarding the treatment of ordinary trade creditors during bankruptcy?

They have higher priority if goods are supplied within 20 days before bankruptcy. Signup and view all the answers

How do lenders minimize potential loss during a default situation?

By structuring credit terms with collateral and covenants. Signup and view all the answers

What is the primary purpose of credit analysis?

To determine the likelihood that a borrower will repay their debt on time and in full Signup and view all the answers

Which of the following is NOT considered a participant in the demand for credit?

Real estate agents Signup and view all the answers

What type of cash needs do companies experience due to cyclical operating activities?

Cyclical cash needs for materials or labor Signup and view all the answers

Which activity requires companies to seek large amounts of cash for investments?

Purchasing property and equipment Signup and view all the answers

What does trade credit typically entail?

Routine, non-interest bearing credit Signup and view all the answers

What might a willing lender provide that can affect a company's survival?

Credit during operational losses Signup and view all the answers

Which of the following is a source of supply for credit analysis?

Credit rating agencies Signup and view all the answers

What does the term 'LBO' refer to in the context of credit demands?

Leverage Buy Out Signup and view all the answers

Which of the following describes the cash needs for covering operating losses?

They might not be temporary and can indicate higher risk Signup and view all the answers

In credit analysis, which of the following represents a demand source for credit?

Investors and individuals Signup and view all the answers

Study Notes

Credit Analysis

Credit analysis is the process of determining a borrower's ability and willingness to meet financial obligations.
The primary purpose of credit analysis is to evaluate the likelihood of a borrower repaying debt on time and in full.
Credit risk is the risk of a borrower failing to meet their financial obligations, leading to a loss for the lender.

Demand and Supply of Credit

The demand for credit comes from various entities such as banks, bond investors, corporations, suppliers, customers, and individuals.
Suppliers of credit include internal corporate credit teams, bank credit analysis teams, credit rating agencies (S&P, Moody's, Fitch), fixed income research firms, and consulting firms.
Companies need credit for operating activities like manufacturing, seasonal purchases, and covering operating losses.
Investing activities such as acquiring property, plant, and equipment, intangible assets, mergers & acquisitions, and leverage buyouts also require credit.
Financing activities like maturing bank loans or bonds, stock repurchases, and other corporate financing activities can create demand for credit.
Trade credit, a form of supplier credit, is generally non-interest bearing, with terms specifying early payment discounts, credit limits, payment terms, and other conditions.
Banks provide various credit facilities, including revolving credit lines for seasonal shortfalls, lines of credit for backup funding, term loans for financing fixed assets, and mortgages for real estate transactions.
Other forms of financing include lease financing, publicly traded debt (commercial paper, bonds, debentures), and credit rating agency-rated debt.

Credit Risk Analysis Process

The credit risk analysis process quantifies potential credit losses to inform lending decisions.
Expected credit loss considers both the debtor's ability to repay and the size of the loss if the debtor defaults.
The chance of default is determined by a company's ability to repay its obligations, which is a function of future cash flow and profitability.
Loss Given Default (LGD) is the potential amount lost if a company defaults on its obligations.
LGD depends on the priority of the claim compared to other existing claims, determined by the U.S. Bankruptcy Code.
Lenders mitigate potential losses through credit limits, collateral requirements, repayment terms, and covenants.

Credit Rating Analysis

Credit rating agencies such as Moody's and S&P Global Ratings analyze macroeconomic, industry, and firm-specific information to assess the chance of default and expected payment in the event of default.
They provide ratings on both debt issues and issuers, aiming to predict loan defaults accurately.
Moody's 9-step credit rating process involves identifying the issuer, reviewing financial statements, conducting industry analysis, determining the borrower's financial risk, assessing key business risk factors, analyzing financial flexibility, evaluating management, incorporating governance and environmental and social considerations, and determining the rating.
S&P Global Ratings uses a similar approach, including financial risk assessment with cash flow ratios, leverage ratios, and other metrics.

The Z-Score Model

Altman's Z-Score model is used to predict bankruptcy risk using various financial ratios.
The Z-Score considers working capital, retained earnings, EBIT, market value of equity, total assets, and sales.
A Z-Score above 3.0 suggests low bankruptcy risk in the short term.

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Description

This quiz explores the fundamentals of credit analysis, including the assessment of a borrower's ability to repay debt and the associated risks. It also delves into the demand and supply mechanisms of credit within various entities, highlighting their roles in the financial ecosystem.