Banking Credit Analysis 5 — Questions and Answers
Question 1: A borrower's interest coverage ratio drops from 4.0x to 1.2x over two years. What is the most likely credit implication?
- Credit upgrade due to improved leverage
- Significant deterioration in ability to service interest payments (Correct answer)
- Stable credit outlook with minor adjustments needed
- No material credit concern as the ratio remains above 1.0x
Correct answer: Significant deterioration in ability to service interest payments
A drop to 1.2x means earnings barely cover interest expense, leaving little cushion for unexpected downturns and indicating serious credit deterioration.
Question 2: In asset-based lending (ABL), which assets typically form the borrowing base?
- Long-term fixed assets and goodwill
- Eligible accounts receivable and inventory (Correct answer)
- Intellectual property and brand value
- Real estate and equipment only
Correct answer: Eligible accounts receivable and inventory
ABL borrowing bases are secured by liquid assets like eligible receivables and inventory, which can be quickly liquidated if the borrower defaults.
Question 3: What is 'covenant-lite' (cov-lite) lending?
- Loans to borrowers with low credit scores
- Loans lacking traditional financial maintenance covenants (Correct answer)
- Loans with reduced interest rates and fees
- Short-term bridge loans with minimal documentation
Correct answer: Loans lacking traditional financial maintenance covenants
Cov-lite loans omit maintenance covenants that require borrowers to meet ongoing financial tests, reducing lender early warning signals and protection.
Question 4: What does 'probability of default' (PD) measure in credit risk analysis?
- The amount the lender would lose if a borrower defaults
- The likelihood that a borrower will fail to meet debt obligations within a specified time horizon (Correct answer)
- The recovery rate on defaulted loans
- The time elapsed between credit downgrade and default
Correct answer: The likelihood that a borrower will fail to meet debt obligations within a specified time horizon
PD quantifies the statistical likelihood of a borrower defaulting over a given period, typically one year, and is central to credit pricing and risk-weighted assets.
Question 5: Which of the following would most likely trigger a material adverse change (MAC) clause in a loan agreement?
- A minor decline in quarterly revenue
- A major lawsuit threatening the borrower's solvency (Correct answer)
- Normal seasonal fluctuations in working capital
- A change in the borrower's CFO
Correct answer: A major lawsuit threatening the borrower's solvency
A MAC clause allows lenders to withdraw or modify financing if a significant negative event materially impairs the borrower's financial condition or ability to repay.
Question 6: How does 'subordinated debt' differ from 'senior secured debt' in a capital structure?
- Subordinated debt has priority over senior secured debt in bankruptcy
- Subordinated debt ranks below senior secured debt in the repayment hierarchy (Correct answer)
- Subordinated debt always has a lower interest rate than senior debt
- Subordinated debt requires no collateral unlike senior secured debt
Correct answer: Subordinated debt ranks below senior secured debt in the repayment hierarchy
Subordinated debt is junior in the capital structure and is repaid after senior secured creditors in a default or bankruptcy, making it riskier and typically higher-yielding.
Question 7: Which of the following is the best example of qualitative analysis in credit underwriting?
- Calculating the borrower's debt-to-income ratio
- Assessing management team experience and industry reputation (Correct answer)
- Computing the loan-to-value ratio on collateral
- Reviewing three years of audited financial statements
Correct answer: Assessing management team experience and industry reputation
Qualitative credit analysis evaluates non-numerical factors such as management quality, competitive positioning, and industry dynamics that affect repayment ability.
Banking Credit Analysis 5
A borrower's interest coverage ratio drops from 4.0x to 1.2x over two years.
What is the most likely credit implication?