BMO Financial Analysis & Risk Evaluation 3 — Questions and Answers
Question 1: A bank calculates that a loan portfolio has a 2% probability of default (PD) and a 45% loss given default (LGD) on a $10M exposure. What is the expected loss?
- $90,000 (Correct answer)
- $200,000
- $450,000
- $900,000
Correct answer: $90,000
Expected Loss = PD × LGD × EAD = 0.02 × 0.45 × $10,000,000 = $90,000.
Question 2: Which financial statement best reveals a company's ability to generate cash from its core business operations?
- Balance sheet
- Income statement
- Statement of cash flows — operating section (Correct answer)
- Statement of shareholders' equity
Correct answer: Statement of cash flows — operating section
The operating section of the cash flow statement shows cash generated from core business activities, excluding financing and investing activities.
Question 3: What does a negative working capital position generally indicate for a retail company like a grocery chain?
- Imminent bankruptcy risk
- Efficient operations where suppliers fund inventory (Correct answer)
- Poor inventory management
- Excessive long-term borrowing
Correct answer: Efficient operations where suppliers fund inventory
Retail companies often run negative working capital because they collect cash quickly from customers while paying suppliers on extended credit terms.
Question 4: In portfolio risk management, what does 'Value at Risk' (VaR) measure?
- The maximum possible loss on a portfolio
- The expected profit over a given time period
- The maximum loss not exceeded at a given confidence level over a specific period (Correct answer)
- The average return adjusted for inflation
Correct answer: The maximum loss not exceeded at a given confidence level over a specific period
VaR estimates the maximum loss a portfolio would not exceed at a specified confidence level (e.g., 95%) over a defined time horizon.
Question 5: A company's interest coverage ratio drops from 8.0x to 2.5x. How should a credit analyst interpret this change?
- The company's profitability has significantly improved
- The company's ability to service debt has materially weakened (Correct answer)
- The company has reduced its debt levels
- The change is immaterial to creditworthiness
Correct answer: The company's ability to service debt has materially weakened
An interest coverage ratio falling from 8.0x to 2.5x signals significantly reduced earnings relative to interest obligations, increasing default risk.
Question 6: When analyzing a corporate bond, which factor most directly affects its credit spread over a risk-free benchmark?
- The issuer's perceived probability of default (Correct answer)
- The bond's coupon payment frequency
- The central bank's benchmark interest rate
- The bond's maturity date only
Correct answer: The issuer's perceived probability of default
Credit spreads primarily reflect the market's assessment of an issuer's default risk — higher perceived default risk leads to wider spreads.
Question 7: A financial analyst notices a company's accounts receivable days outstanding increased from 35 to 68 days. What is the most concerning implication?
- The company is collecting cash from customers faster
- Customers are taking longer to pay, potentially signaling collection issues or aggressive revenue recognition (Correct answer)
- The company has reduced its sales force
- Interest rates have increased
Correct answer: Customers are taking longer to pay, potentially signaling collection issues or aggressive revenue recognition
A sharp increase in DSO suggests customers are paying more slowly, which may indicate credit quality deterioration or revenue recognition problems.
BMO Financial Analysis & Risk Evaluation 3
A bank calculates that a loan portfolio has a 2% probability of default (PD) and a 45% loss given default (LGD) on a $10M exposure.
What is the expected loss?