READING 62 CREDIT ANALYSIS FOR CORPORATE ISSUERS Flashcards
(52 cards)
Which of the following best describes the business model of a high-credit-quality issuer?
A. One that maximizes short-term earnings through aggressive expansion.
B. One that generates stable and predictable cash flows over time.
C. One that focuses primarily on rapid changes to adapt to competitors.
Correct Answer: B
Explanation:
B is correct – High-credit-quality companies typically have stable and predictable cash flows, which lowers the likelihood of default.
A is incorrect – Aggressive expansion can increase risk and reduce creditworthiness.
C is incorrect – Frequent changes increase business risk and are not ideal for long-term debt stability.
When evaluating the long-term creditworthiness of a corporate issuer, a credit analyst should:
A. Focus solely on historical financial performance.
B. Only consider the current business model.
C. Consider both the current and potential future changes to the business model.
Correct Answer: C
Explanation:
C is correct – Analysts must assess whether the company’s business model can remain competitive over the long term.
A is incorrect – Historical performance is useful but insufficient.
B is incorrect – Ignoring future adaptability underestimates long-term business risk.
All else equal, which of the following industry characteristics is most favorable for a company’s credit quality?
A. Highly fragmented and competitive industry.
B. Industry with significant barriers to entry and few players.
C. Market with high customer turnover and innovation demands.
Correct Answer: B
Explanation:
B is correct – Less competition and strong industry position support stable cash flows.
A is incorrect – Fragmented industries often have margin pressures and volatility.
C is incorrect – Constant innovation demands can raise business risk.
Which of the following is a likely source of business risk?
A. Predictable seasonal revenue patterns.
B. Shifts in industry regulation.
C. Stable gross margins across product lines.
Correct Answer: B
Explanation:
B is correct – Regulatory changes are an external source of business risk.
A is incorrect – Predictable patterns are manageable, not risky.
C is incorrect – Stable margins reduce business risk.
Business risk for a corporate bond issuer may originate from:
A. Equity issuance decisions.
B. Off-balance-sheet leasing.
C. Industry-specific and external factors.
Correct Answer: C
Explanation:
C is correct – Business risk includes internal (issuer-specific), industry, and macroeconomic/external elements.
A is incorrect – Equity issuance affects capital structure, not directly business operations.
B is incorrect – This is more related to financial transparency, not operational risk.
Which of the following is an example of good corporate governance from a creditor’s perspective?
A. Prioritizing equity shareholder dividends during financial stress.
B. Implementing transparent financial reporting and honoring debt covenants.
C. Using aggressive accounting practices to boost reported earnings.
Correct Answer: B
Explanation:
B is correct – Fair treatment of debtholders and transparency reflect strong governance.
A is incorrect – Favoring shareholders over bondholders is a red flag.
C is incorrect – Aggressive accounting reduces transparency and raises concerns.
Affirmative covenants typically include:
A. Restrictions on paying dividends or issuing new debt.
B. Requirements to comply with laws and maintain assets.
C. Limits on management’s compensation practices.
Correct Answer: B
Explanation:
B is correct – Affirmative covenants are obligations the issuer agrees to perform (e.g., tax payment, compliance).
A is incorrect – These are negative covenants.
C is incorrect – This is not a typical covenant clause.
Which type of issuer is most likely to have negative covenants in its debt agreements?
A. High-credit-quality, secured issuers.
B. Unsecured investment-grade issuers.
C. High-yield issuers with elevated credit risk.
Correct Answer: C
Explanation:
C is correct – High-yield issuers typically face more restrictions to protect creditors.
A is incorrect – High-quality issuers often need fewer restrictions.
B is incorrect – These usually have only affirmative covenants.
Why must analysts assess the potential for a company to issue new debt?
A. It may lead to overcompliance with affirmative covenants.
B. It can increase the seniority of existing debtholders.
C. It may dilute existing debtholders’ claims and increase credit risk.
Correct Answer: C
Explanation:
C is correct – More debt increases obligations and may reduce recovery for current debtholders.
A is incorrect – Overcompliance isn’t a concern.
B is incorrect – New debt generally reduces, not enhances, seniority.
A debt-financed stock buyback program is a red flag for creditors primarily because:
A. It reduces the company’s dividend payout.
B. It signals aggressive expansion plans.
C. It may favor shareholders over debtholders and weaken the company’s credit profile.
Correct Answer: C
Explanation:
C is correct – Taking on more debt to reward shareholders may increase credit risk and lead to downgrades.
A is incorrect – Reducing dividends may help credit quality.
B is incorrect – Stock buybacks are not expansion investments.
An analyst observes that a firm frequently changes its CFO and external auditors. This most likely indicates:
A. Strong cost control.
B. Conservative accounting practices.
C. Potential governance or transparency concerns.
Correct Answer: C
Explanation:
C is correct – Frequent changes may suggest internal issues or management’s desire to avoid scrutiny.
A is incorrect – This doesn’t suggest cost control.
B is incorrect – It may suggest the opposite.
Which of the following accounting practices is most likely to raise concerns for a credit analyst?
A. Immediate expensing of development costs.
B. Recognizing revenue before goods are delivered.
C. Gradual depreciation of fixed assets over their useful lives.
Correct Answer: B
Explanation:
B is correct – Early revenue recognition is an aggressive policy and may mislead investors.
A is incorrect – This is a conservative approach.
C is incorrect – Straight-line depreciation is standard practice.
Why is off-balance-sheet financing a concern for credit analysts?
A. It artificially lowers reported liabilities.
B. It increases reported cash flows.
C. It raises shareholder equity.
Correct Answer: A
Explanation:
A is correct – This hides true financial obligations, underestimating leverage and risk.
B is incorrect – Cash flows may remain unchanged.
C is incorrect – It doesn’t impact equity directly.
A company that capitalizes a large portion of its spending rather than expensing it immediately is most likely:
A. Improving current period profitability at the risk of future accuracy.
B. Complying with affirmative covenants.
C. Reducing its leverage ratio transparently.
Correct Answer: A
Explanation:
A is correct – Capitalizing spreads out expenses, which boosts short-term profits but may mislead.
B is incorrect – This has no direct link to covenants.
C is incorrect – Capitalizing doesn’t change leverage directly.
Which of the following best describes why corporate governance is important in credit analysis?
A. It ensures the company will increase dividends over time.
B. It protects equity investors from bondholder actions.
C. It promotes fair treatment and transparency toward debtholders.
Correct Answer: C
Explanation:
C is correct – Strong governance includes honoring covenants, financial transparency, and fair creditor treatment.
A is incorrect – Dividends are not a focus of credit analysts.
B is incorrect – Credit analysis is focused on debtholder interests, not shareholders.
Which of the following best describes the purpose of quantitative modeling in corporate credit analysis?
A. To evaluate qualitative risk factors such as management competence and governance policies.
B. To estimate future performance and identify factors affecting default probability and potential losses.
C. To determine the market value of a firm’s equity relative to its competitors.
Correct Answer: B
Explanation:
B is correct: Quantitative modeling focuses on forecasting future financials and cash flows to assess default risk and loss given default, particularly under different economic conditions.
A is incorrect: While qualitative factors are important in credit analysis, they are not part of quantitative modeling, which is data-driven.
C is incorrect: Valuation of equity may use similar techniques, but the objective here is credit risk, not relative equity valuation.
Which investor is most concerned with loss given default in corporate credit analysis?
A. An investor in unsecured investment-grade bonds.
B. An investor in secured high-yield bonds.
C. An investor in Treasury securities.
Correct Answer: B
Explanation:
B is correct: Secured high-yield bond investors face a higher probability of default, making loss given default (LGD) a critical consideration.
A is incorrect: Investment-grade bondholders are more focused on the probability of default, as it’s relatively low.
C is incorrect: Treasury securities are default risk-free, so LGD is not relevant.
Top-down credit analysis is most likely to include:
A. Evaluating trends in a company’s receivables turnover and interest coverage.
B. Analyzing the potential impact of macroeconomic conditions and industry size.
C. Examining firm-specific operating cash flow projections.
Correct Answer: B
Explanation:
B is correct: Top-down analysis starts with the macro environment, such as the economic cycle, industry trends, and external risks.
A is incorrect: This refers to bottom-up, company-specific analysis.
C is incorrect: Operating cash flows are a bottom-up input tied to issuer-level data.
A bottom-up credit analysis is least likely to consider:
A. A company’s debt-to-equity ratio.
B. A company’s recurring revenue from long-term contracts.
C. Interest rate expectations set by the central bank.
Correct Answer: C
Explanation:
C is correct: Central bank interest rate policy is a macroeconomic factor, part of top-down analysis.
A is incorrect: The debt-to-equity ratio is a bottom-up indicator of financial leverage.
B is incorrect: Recurring revenues from long-term contracts are a company-level (bottom-up) stability indicator.
Which of the following firms would most likely be considered to have high credit quality, assuming all other factors are equal?
A. Firm A: Strong recurring revenues, high debt usage, and weak liquidity.
B. Firm B: High coverage of debt service payments and low leverage.
C. Firm C: Volatile earnings, strong liquidity, and no history of defaults.
Correct Answer: B
Explanation:
B is correct: High debt coverage and low leverage are key signs of credit quality.
A is incorrect: High debt and poor liquidity increase credit risk.
C is incorrect: While liquidity helps, volatile earnings hurt the company’s ability to make regular debt payments.
Which approach best describes a hybrid credit analysis framework?
A. Analyzing only macroeconomic conditions such as GDP growth and interest rates.
B. Combining macroeconomic trends with firm-specific performance indicators.
C. Using financial ratio analysis to assess management efficiency.
Correct Answer: B
Explanation:
B is correct: A hybrid approach blends top-down (macroeconomics) and bottom-up (company-level) factors.
A is incorrect: This is purely top-down.
C is incorrect: Ratio analysis is bottom-up and does not reflect a hybrid approach.
Which of the following is most likely to improve a company’s credit profile from a quantitative standpoint?
A. Increasing reliance on short-term debt to meet operating needs.
B. Reducing leverage and increasing recurring income streams.
C. Expanding rapidly into new, untested markets with high capital requirements.
Correct Answer: B
Explanation:
B is correct: Lower leverage and stable income improve the company’s ability to meet obligations, enhancing creditworthiness.
A is incorrect: Reliance on short-term debt increases liquidity risk and may hurt credit quality.
C is incorrect: Expansion with high capital needs and risk adds uncertainty, which may weaken the credit profile.
Which of the following best describes the purpose of calculating credit analysis ratios?
A. To determine a company’s share price potential
B. To assess the company’s cash flow volatility
C. To evaluate creditworthiness, trends, and peer comparisons
Correct Answer: C
Explanation:
Credit analysis ratios are used to assess a company’s creditworthiness, identify trends over time, and compare it to peers and industry benchmarks.
A is incorrect – share price relates to equity valuation, not creditworthiness.
B is too narrow – cash flow volatility is a small part of a larger credit picture.
Which ratio is most appropriate to assess a firm’s ability to service its debt from operating earnings?
A. EBIT margin
B. Interest coverage ratio
C. Debt-to-equity ratio
Correct Answer: B
Explanation:
The interest coverage ratio (EBIT/interest expense) shows how well operating income can cover interest obligations.
A is a profitability measure, not directly about debt.
C is a leverage measure, not coverage.
