Credit Risk

Homework Assignment – Chapter 5
1. When a financial analyst examines the credit risk of a company, it is common that he or she uses a set
of factors that all begin with the letter “C.” Each factor provides a consideration that enters into
the lending decision. List and discuss how each of the factors affects a company’s credit risk.
ANS:
1. Circumstances leading to need for the loan – The reasons that the company needs to borrow
affect the riskiness of the loan and the likelihood of repayment.
2. Credit History – Has the firm borrowed in the past and successfully repaid the loan.
3. Cash flows – Is the lender generating sufficient cash flows to pay interest and repay the
principal on a loan rather than having to rely on selling the collateral.
4. Collateral – Is the collateral sufficient to repay the loan and does the lender have the right to
take possession of the collateral.
5. Capacity for debt – Has the company borrowed up to its capacity or is there a margin of
safety remaining.
6. Contingencies – Are there any events on the horizon that would harm the company if their
outcome is negative.
7. Character of management – An intangible factor, has the management team been successful
in difficult times, are they honest and forthcoming.
8. Communication – Developing relations with lenders requires effective communication both
initially and on an ongoing basis.
9. Conditions – What are the restrictions or covenants put in place to protect the lender.
Each of these factors must be examined in the multivariate manner so that the total credit risk
profile of the company can be determined.