Credit Quality of a Potential Debt Investment

Credit Quality of a Potential Debt Investment

The analysis of a company’s historical and projected financial statements is an integral part of the credit evaluation process. It helps determine a company’s ability to meet its debt obligations.

Several financial ratios may be computed from these financial statements. The ratios help to assess the credit quality of a potential debt investment based on the issuer’s perceived ability to honor its debt obligations, i.e., repaying the principal and making interest payments.

The Role of Financial Statement Analysis in Assessing Credit Quality

A company’s financial statements, both historical and projected, are important sources of information for assessing credit quality. Whereas computation of a company’s financial ratios is useful in the determination of its creditworthiness, the company’s relative creditworthiness may be determined by comparing its financial ratios with those of its peers. Commonly used financial ratios for this purpose include EBITDA/Average assets; Debt/EBITDA; Retained cash flow to debt; and Free cash flow to net debt.

Additionally, credit analysis, or the evaluation of credit risk, involves the projection of a company’s period-by-period cash flows. It uses return measures related to operating cash flow because this represents the cash that is generated internally and is available for the payment of creditors.

Four groups of quantitative factors are used in credit analysis:

  • scale and diversification: this relates to a company’s sensitivity to adverse events or economic conditions, and other factors such as access to capital markets, that may affect its debt-paying ability;
  • tolerance for leverage: this relates to a company’s ability to service its indebtedness;
  • operational efficiency: this relates to a company’s cost structure. Companies that have lower costs are better positioned to deal with financial stress; and
  • margin stability: this relates to the past volatility of profit margins. Higher margin stability is associated with lower credit risk.

Question

Two companies have the same size. One of them operates in a more diversified market. The company in the more diversified market would most likely have:

  1. The same credit score, since the size of the company is all that matters.
  2. A higher credit score, since diversification creates a steady stream of cash flows.
  3. A lower credit score, since its business is fragmented and this makes it harder to manage.

Solution

The correct answer is B.

The company in a diversified market would have a better credit score. A higher degree of diversification would enhance the stability of the company’s stream of cash flow. This would, in turn, boost its capacity to pay the principal and interests of its debt.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.