Financial Analysis & Risk Assessment Flashcards

What is the primary purpose of financial ratio analysis in credit risk assessment?

Answer: To assess the borrower's financial health and repayment capacity.

The primary purpose of financial ratio analysis in credit risk assessment is to evaluate a borrower's financial health and their capacity to repay debt. Ratios provide insights into liquidity, solvency, profitability, and efficiency, allowing lenders to gauge the risk associated with extending credit and make informed decisions.

Which ratio measures a company's ability to meet short-term obligations?

Answer: Current Ratio

The Current Ratio is specifically designed to measure a company's ability to meet its short-term obligations. It compares current assets (assets convertible to cash within a year) to current liabilities (debts due within a year), providing a snapshot of the company's liquidity and operational solvency.

What does a high Debt-to-Equity (D/E) ratio indicate about a company?

Answer: The company relies heavily on debt financing.

A high Debt-to-Equity (D/E) ratio indicates that a company relies heavily on debt financing rather than equity to fund its operations and assets. This suggests higher financial leverage and potentially greater risk, as the company has a larger obligation to external creditors compared to its owners' investment.

Which of the following is a key component of the '5 Cs of Credit'?

Answer: Capacity (to repay)

Capacity is a key component of the '5 Cs of Credit,' referring to the borrower's ability to generate sufficient cash flow to repay the loan. Lenders assess this by analyzing income, expenses, and existing debt obligations to determine if the borrower can comfortably meet their financial commitments.

What is the purpose of stress testing in financial risk assessment?

Answer: To assess how a company performs under extreme conditions.

Stress testing in financial risk assessment involves simulating extreme, yet plausible, adverse economic scenarios to evaluate a company's resilience. Its purpose is to assess how a company's financial position would hold up under severe conditions, helping identify vulnerabilities and potential losses before they occur.

Which financial statement is most critical for assessing cash flow risk?

Answer: Statement of Cash Flows

The Statement of Cash Flows is most critical for assessing cash flow risk because it directly reports the cash generated and used by a company from its operating, investing, and financing activities. This statement provides a clear picture of a company's liquidity and its ability to meet short-term obligations and fund future growth.

What does Altman Z-score predict?

Answer: Probability of corporate bankruptcy

The Altman Z-score is a widely recognized financial model used to predict the probability of corporate bankruptcy. It combines several financial ratios into a single score, providing an early warning indicator of a company's financial distress and potential insolvency.

Which risk arises from changes in interest rates affecting loan repayments?

Answer: Interest Rate Risk

Interest Rate Risk specifically arises from changes in market interest rates, which can affect the cost of borrowing for a company or the value of its investments. For loan repayments, fluctuations in interest rates can alter the financial burden on borrowers or the profitability for lenders.

What is the primary goal of credit risk mitigation techniques like collateralization?

Answer: To minimize potential losses in case of default

The primary goal of credit risk mitigation techniques like collateralization is to minimize potential losses for the lender in case of borrower default. By requiring collateral, the lender has an asset to seize and sell if the borrower fails to repay, thereby reducing their financial exposure and risk.