Account for the elements that make up credit risk analysis.

FRM® Part II · Credit Risk Measurement and Management · Credit Risk Management · FRM2.CR.3.i

The idea

Credit risk analysis assesses the borrower's ability and willingness to repay and what the bank recovers if it does not. Its elements are the purpose and structure of the request, and the business and industry, including competitive position and cyclicality. They also include management quality and character. Financial analysis covers profitability, leverage, liquidity and cash flow, using ratios such as interest coverage (EBIT ÷ interest), leverage (debt ÷ EBITDA) and the debt service coverage ratio (cash flow available ÷ interest plus principal). The last elements are projections under base and stress cases, collateral and guarantees, and conditions and covenants. The classic summary is the five Cs: character, capacity, capital, collateral and conditions. The primary source of repayment is operating cash flow and collateral is secondary, so capacity is judged first and strong collateral does not rescue weak cash flow.

Formulas

Debt service coverage ratio

DSCR = cash flow available for debt service ÷ debt service

cash flow available for debt service: operating cash flow left to pay lenders
debt service: the interest and scheduled principal due in the period

Debt service is interest plus scheduled principal. Below one, the borrower cannot pay from operations; stress cash flow and rates together.

Interest coverage

interest coverage = EBIT ÷ interest payments

EBIT: earnings before interest and tax
interest payments: the interest due in the period

EBIT is EBITDA less depreciation and amortisation. Using EBITDA here overstates coverage.

Leverage

leverage = total debt ÷ EBITDA

total debt: all debt ranking in the capital structure
EBITDA: earnings before interest, tax, depreciation and amortisation

Divide by EBITDA, not EBIT. Higher leverage means weaker capacity to repay.

A practice question

From the question bank, with the reason each wrong option is wrong.

In credit risk analysis, the primary source of repayment is normally:

The sale of the pledged collateral.Why not: Collateral is a secondary source, used if cash flow fails.
The assets of a guarantor.Why not: A guarantee is a secondary source.
The borrower's operating cash flow. - correct
Refinancing by another lender.Why not: Refinancing is a tertiary source and depends on market access.

Lenders expect repayment from the cash the business generates. Collateral, guarantees and refinancing are secondary or tertiary sources.

A harder one

A borrower's cash flow available for debt service is USD 4.8 million. Scheduled interest is USD 1.7 million and scheduled principal repayments are USD 2.5 million. The debt service coverage ratio is closest to:

2.82Why not: Divides by interest only, which is an interest coverage figure.
1.14 - correct
1.92Why not: Divides by principal only and omits interest.
0.88Why not: Inverts the ratio, dividing debt service by cash flow.

DSCR = cash flow available for debt service / (interest + principal) = 4.8 / 4.2 = 1.14.

The hardest tier

A borrower has USD 30 million of floating-rate debt at 6 percent, scheduled principal of USD 2.0 million a year and cash flow available for debt service of USD 5.0 million. Analysts stress the credit: cash flow falls 25 percent and the interest rate rises by 200 basis points. The stressed DSCR is closest to:

0.99Why not: Applies only the cash flow shock and leaves the rate at 6 percent.
1.14Why not: Applies only the rate shock and leaves the cash flow unchanged.
0.85 - correct
0.79Why not: Treats the rate shock as a 25 percent rise in debt service.

Stressed cash flow = 5.0 x 0.75 = 3.75. Stressed interest = 30 x 8% = 2.40; debt service = 2.40 + 2.00 = 4.40. DSCR = 3.75 / 4.40 = 0.85. Combined shocks show weakness a single-factor stress would miss.

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