CCM Credit Risk Evaluation 3 — Questions and Answers
Question 1: Which element of the 'Five Cs of Credit' evaluates the economic environment and industry conditions?
- Character
- Capacity
- Conditions (Correct answer)
- Collateral
Correct answer: Conditions
Conditions refers to external factors such as the economic climate, industry trends, and market conditions that may affect a borrower's ability to repay.
Question 2: A credit analyst notices a customer's accounts payable days have increased from 45 to 90 over two years. This most likely indicates:
- Improved supplier relationships and negotiated terms
- The company is generating stronger cash flow
- The company may be stretching payables due to cash flow stress (Correct answer)
- A reduction in purchasing activity
Correct answer: The company may be stretching payables due to cash flow stress
A sharp increase in payable days often signals that a company is delaying supplier payments due to cash flow difficulties, a red flag in credit evaluation.
Question 3: Under the Uniform Commercial Code (UCC), a 'perfected security interest' provides a creditor with:
- The right to charge higher interest rates
- Priority claim over the collateral against other creditors (Correct answer)
- Automatic recourse to the debtor's personal assets
- Immunity from preference claims in bankruptcy
Correct answer: Priority claim over the collateral against other creditors
Filing a UCC-1 financing statement perfects a security interest, giving the creditor a priority claim over the specified collateral in the event of default or bankruptcy.
Question 4: Which ratio is most useful for assessing a company's ability to service its debt from operating earnings?
- Current ratio
- Gross margin
- Interest coverage ratio (EBIT/Interest expense) (Correct answer)
- Return on equity
Correct answer: Interest coverage ratio (EBIT/Interest expense)
The interest coverage ratio measures how many times a company's operating earnings can cover its interest expense, directly assessing debt service capacity.
Question 5: A guaranty agreement differs from a surety agreement primarily because:
- A guaranty covers only secured debt while surety covers unsecured debt
- A guarantor's obligation is secondary and conditional, while a surety's is primary and unconditional (Correct answer)
- A surety requires collateral while a guaranty does not
- A guaranty is only valid for commercial transactions, not consumer credit
Correct answer: A guarantor's obligation is secondary and conditional, while a surety's is primary and unconditional
A guarantor is only liable after the primary debtor defaults, whereas a surety is co-equally liable from the outset and the creditor can pursue either party immediately.
Question 6: Credit scoring models used for commercial credit evaluation typically weigh which factor most heavily?
- The number of trade references provided
- Payment history and timeliness of past obligations (Correct answer)
- The age of the company's physical premises
- The number of employees
Correct answer: Payment history and timeliness of past obligations
Payment history is consistently the most heavily weighted factor in commercial credit scoring as it is the strongest predictor of future payment behavior.
Question 7: A company reports net income of $200,000 but negative cash flow from operations of -$150,000. This divergence most likely indicates:
- The company is investing heavily in capital equipment
- Aggressive accrual accounting or working capital deterioration (Correct answer)
- The company recently paid a large dividend
- Strong revenue growth with delayed billing
Correct answer: Aggressive accrual accounting or working capital deterioration
Positive net income alongside negative operating cash flow is a red flag suggesting earnings quality issues, potentially from aggressive accruals or a buildup of receivables and inventory.
CCM Credit Risk Evaluation 3
Which element of the 'Five Cs of Credit' evaluates the economic environment and industry conditions?