Question 1

The five Cs of credit are financial capacity,collateral,conditions,connections with the bank,and capital.

Accepted Answer

The five Cs of credit are character, capacity, capital, collateral, and conditions, not connections with the bank.

Question 2

Management of credit risk is achieved through diversification effect by combining numerous loans in a portfolio.

Accepted Answer

Diversification helps to spread the risk across multiple loans or borrowers, reducing the impact of any one loan defaulting or becoming overdue. Therefore, managing credit risk through diversification is an effective strategy.

Question 3

Issuance of short-term debt would result in an increase in cash flow from operations on the statement of cash flows.

Accepted Answer

Issuance of short-term debt increases cash flow from financing activities, not from operations. Cash flow from operations relates to the core business activities of the company.

Question 4

The risk-adjusted return on capital (RAROC)model calculates the actual or promised annual cash flow on a loan as a percentage of the amount lent.

Accepted Answer

RAROC is a risk management tool that measures the risk-adjusted return of a financial transaction by dividing the economic value added by the amount of risk. It does not specifically calculate annual cash flow as a percentage of the amount lent.

Question 5

Credit analysis of a mid-market corporate borrower differs from the analysis of a small business in that the analysis of the mid-market borrower is more focused on the business itself and less on the business owners.

Accepted Answer

Credit analysis of a mid-market corporate borrower is more focused on the business itself, including its financial position, operations, and industry environment, while credit analysis of a small business is often more focused on the strength and track record of the business owner or owners.

Question 6

Individuals with higher levels of income must have higher GDS and TDS ratios to qualify for a loan.

Accepted Answer

The GDS and TDS ratios are based on the borrower's income and expenses, so a higher income does not necessarily mean a higher ratio is needed to qualify for a loan. The ratios depend on factors such as the loan amount, interest rate, and other debt obligations.

Question 7

A firm's cash account grew by $300 over the year when the firm had cash flow from financing of −$150 and cash flow from investing of $100. The firm's operating cash flow must have been +$250.

Accepted Answer

The firm's cash flow statement can be represented as:

Operating Cash Flow (OCF) = $250
Cash Flow from Investing Activities (CFIA) = $100
Cash Flow from Financing Activities (CFFA) = -$150

Net Increase in Cash = CFIA + CFFA = $100 - $150 = -$50

This means that the firm's cash account should have decreased by $50 over the year, contradicting the given information that it grew by $300. Therefore, the statement is false.

Question 8

If you were a loan officer evaluating a small business credit application for a loan secured by working capital,you would generally want to see a higher (rather than lower)number of days in inventory and number of days' sales in receivables.

Accepted Answer

A higher number of days in inventory and number of days' sales in receivables would indicate that the small business is taking longer to sell their products and collect payment from customers, which could potentially be a red flag for the loan officer. A lower number of days in inventory and receivables would indicate a faster turnover and better cash flow management.

Question 9

The more variable a borrower's cash flows are,the lower the fixed charge coverage ratio should be to limit risk.

Accepted Answer

The fixed charge coverage ratio measures a company's ability to cover its fixed charges (such as interest and lease expenses) with its earnings. A higher ratio indicates a better ability to cover these charges, thus reducing risk. If a borrower's cash flows are more variable, a higher fixed charge coverage ratio would be preferable to provide a larger buffer and limit risk.

Question 10

Credit scoring models are probabilistic models based on economic and financial borrower characteristics aiming to determining the likelihood of default of a borrower.

Accepted Answer

Credit scoring models are indeed probabilistic models that use various borrower characteristics to predict the probability of default.

Question 11

Asset management ratios are used in credit analysis to help understand the borrower's ability to generate sales from the amount invested in some asset category.

Accepted Answer

Asset management ratios such as asset turnover ratio, inventory turnover ratio, and receivables turnover ratio are used in credit analysis to evaluate the efficiency of a borrower in managing their assets and generating sales.

Question 12

Collateral on a mortgage is normally only considered if the applicant has enough income to service the loan.

Accepted Answer

Lenders typically assess an applicant's income to ensure they can afford the loan payments before considering the collateral as a secondary factor for securing the mortgage.

Question 13

Analysis of the statement of cash flows involves assessment of operating,financing and investing cash flows and analysis of the resulting net income.

Accepted Answer

Analysis of the statement of cash flows involves assessment of operating, financing, and investing cash flows to understand the cash movements within a company, but it does not directly analyze resulting net income, as net income is derived from the income statement, not the cash flow statement.

Question 14

Provision for loan losses,net charge-offs,and the percentage of nonperforming loans all increased dramatically in 2007.

Accepted Answer

The statement clearly indicates that there was an increase in loan losses, net charge-offs, and nonperforming loans in 2007.

Question 15

Gross debt service usually must be greater than 30 percent before a residential mortgage will be approved.

Accepted Answer

Gross debt service (GDS) ratio typically must be less than or equal to 30-32% for a residential mortgage to be approved, as it measures the portion of the borrower's income that will go towards housing costs.

Question 16

Junk bonds usually yield lower returns than investment-grade bonds due to their speculative feature.

Accepted Answer

Junk bonds, also known as high-yield bonds, typically offer higher yields than investment-grade bonds to compensate investors for the higher risk involved. This means that junk bonds usually yield higher returns than investment-grade bonds.

Question 17

If you are a lender evaluating a loan application and you calculate the following ratio: (EBIT + Lease Payments)/[Interest + Lease Payments + (Sinking Fund/(1 − T))],then you are calculating a debt service ratio and it should be less than one in order to approve the loan.

Accepted Answer

This ratio is a measure of a company's ability to cover its debt obligations, but there is no universal rule that it should be less than one to approve a loan. Generally, a higher ratio indicates better ability to service debt, and lenders may have different thresholds for what they consider acceptable.

Question 18

As long as overall cash flow growth is positive,a bank loan officer would not be concerned if cash flow from operations was projected to be negative over the term of the loan.

Accepted Answer

A bank loan officer would be concerned if the cash flow from operations is projected to be negative over the term of the loan, as it indicates that the business may not be able to generate sufficient cash flow to cover its operating expenses and debt obligations. This could increase the risk of defaulting on the loan, which the loan officer would want to avoid.

Question 19

A rising sales to working capital ratio may indicate a potential borrower is using its net current assets more efficiently.

Accepted Answer

A rising sales to working capital ratio indicates that a company is generating more sales revenue for each dollar of working capital invested, indicating more efficient use of net current assets.

Question 20

Residential mortgage loan applications have the most diverse application processes that differ from one institution to the other.

Accepted Answer

While there may be variations in the specifics of the application process from one institution to another, residential mortgage loan applications in many countries are largely standardized due to regulations and industry practices, ensuring a relatively uniform process across different lenders.

Quiz 20: Managing Credit Risk on the Balance Sheet