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CFI CBCA FINANCIAL ANALYSIS FOR CREDIT EXAM QUESTIONS AND ANSWERS
(VERIFIED AND UPDATED)
“Course Objectives - CORRECT ANSWER -Understand the components that go into financial
analysis -Calculate the key performance ratios that credit professionals use to assess a company's profitability and efficiency -Calculate the key financial ratios used to assess a company's liquidity, leverage, and coverage -Undertake a vertical analysis to determine profitability from the income statement and proportionality from the balance sheet -Undertake horizontal analysis to spot trends and analyze their meaning -Perform industry benchmarking" "Financial analysis is frequently conducted within the context of a specific borrowing request.
Lenders must - CORRECT ANSWER overlay the proposed credit facilities and loan terms on
top of financial results to see how financial metrics are impacted."
"A credit professional may conduct the analysis using - CORRECT ANSWER actual
current/historical results, as well as using projected operating results." "Financial Ratios Financial condition of the company; liquidity, solvency, and how operating cash flow covers
principal & interest obligations - CORRECT ANSWER Coverage
Leverage Liquidity"
"Breaking down the income statement - CORRECT ANSWER Sales Revenue
Cost of Good Sold Gross Profit Indirect Costs Research & Development Marketing & Sales"
"Taxes - CORRECT ANSWER include both current and future income taxes, which are
deducted from earnings before tax."
"Net Income/Profit - CORRECT ANSWER is the final part of the income statement and
represents what is remaining to be paid to the shareholders"
"Credit professionals should focus on the most important profitability ratios. - CORRECT
ANSWER Gross Profit Margin
Operating Profit Margin EBITDA Margin Net Profit Margin"
"Gross Profit Margin = - CORRECT ANSWER Gross Profit / Revenue"
"Gross Profit Margin - CORRECT ANSWER -Tells us, for every $1 of revenue generated, how
much is left over after paying the cost of goods sold. -This amount is used to pay for all other costs related to running the company."
"Gross Profit = - CORRECT ANSWER Revenue - COGS"
"Operating Profit Margin = - CORRECT ANSWER EBIT / Revenue
This ratio normalizes for different tax rates and capital structure decisions."
"Publicly-traded industry comparable companies - CORRECT ANSWER • Information from
an issuer's MD&A can be found using public filing systems like EDGAR, SEDAR, and RNS
- Third-party data providers do not always calculate ratios the same way
- Using external data providers may require you to make adjustments before ratios become usable for your comparable analysis"
"Efficiency & Liquidity - CORRECT ANSWER Ratio Analysis"
"Performance Ratios - CORRECT ANSWER Breaking Down the Balance Sheet"
"Efficiency ratios look at - CORRECT ANSWER how efficiently a company is using its assets.
To calculate these ratios, both the income statement and the balance sheet are used."
"Asset Turnover Ratio - CORRECT ANSWER = Net Sales / Total (or net) Assets
Indicates how many dollars of revenue are generated for every dollar of assets."
"Credit professionals tend to focus on efficiency ratios related to - CORRECT ANSWER
working capital; efficient cash management leads to a higher probability of a strong management team, a sustainable company, and the capacity to repays debts."
"Working Capital Formula - CORRECT ANSWER Current Assets - Current Liabilities
"Residual Claims - CORRECT ANSWER Receive residual amounts after all other creditors"
"Many prudent lenders will include - CORRECT ANSWER preferred share dividends as
annual obligations when calculating coverage ratios."
"Acceptable - CORRECT ANSWER 1:1, 2:1"
"Highly levered (risky) - CORRECT ANSWER 1:
-Higher repayment obligations -Weaker credit metric -Must be offset with strength in a different credit metric (E.g. robust collateral or compelling character rationale)"
"Two alternatives to the debt to equity ratio are: - CORRECT ANSWER -Total Liabilities to
Equity -Total Liabilities to Total Capital"
"Total Liabilities to Equity - CORRECT ANSWER Total Liabilities (All liabilities, not only
funded debt) / Total Equity"
"Total Liabilities to Total Capital - CORRECT ANSWER Total Liabilities / Debt + Equity
(Relative to total funding sources)"
"Total Liabilities to Tangible Net Worth - CORRECT ANSWER A large part of being a good
credit analyst is mitigating loan loss in the event of a default. An important consideration is the degree to which you can realize the value of the collateral pledged as security."
"Good Underlying Tangible Value - CORRECT ANSWER AR
Real Estate Manufacturing Equipment"
"Poor Underlying Tangible Value - CORRECT ANSWER Goodwill
Related party loans Building improvements Prepaid expenses"
"Total liabilities to tangible net worth helps you understand - CORRECT ANSWER what kind
of coverage you have using good, physical, saleable assets as collateral, relative to total liabilities outstanding."
"Total Liabilities to Total Capital = - CORRECT ANSWER = Total Liabilities / (Equity -
Intangible Assets) Like debt to equity, a ratio of 1:1 or less is preferred. This implies low leverage or high levels of tangible assets. However, a high number is not a deal breaker. There are some industries where intangible assets tend to make up a disproportionately large percentage of total assets (e.g. technology industry)."
"Funded Debt to Tangible Net Worth - CORRECT ANSWER Current + Long-Term Portions of
Existing & Proposed New Credit Facilities / (Total Equity - Intangible Assets) While there is no ultimately correct method, it is important you are consistent when calculating metrics."
"Loan Pricing - CORRECT ANSWER We will be providing you with 'test rates' as we work
through examples in this course. These are placeholder rates that help you calculate debt service coverage and will approximate the range your client is likely to see. The cost of funds is a function of the lender's funding source(s)."
"Test Rate = - CORRECT ANSWER = Market Rate + Buffer (Helps sensitize a client's
operating results to ensure they can still service debt in the event of a material increase in interest rates)"
"There are two key components to the borrower's all-in rate: - CORRECT ANSWER Lender's
Cost of Funds and Client's Credit Spread"
"Private Lenders - CORRECT ANSWER Funding derived from yield-seeking investors Issues
bonds at higher rates Issues bonds at lower rates Higher Cost of Funds"
"Commercial Bank - CORRECT ANSWER Funding derived from client deposits into checking
accounts Can borrow from central and other banks Issues bonds at lower rates Lower Cost of Funds" "While DSCR is sensitive to changes in interest rates (so a test rate is recommended), it is
especially sensitive to - CORRECT ANSWER the amortization period of a loan."
"Company A Longer Amortization Period - CORRECT ANSWER • Smaller annual obligations:
- Higher/better DSCR despite same leverage
General Insights - CORRECT ANSWER -Management Salary
-Appears as income statement expense item, thus reduces NI, decreases EBITDA, reduces DSCR -Decreases NI, less flows through to the balance sheet. The lower EBITDA also increase FD/EBITDA - both negative -Reduces corporate income tax. However, least effective way to pay oneself since personal income tax is generally higher than corporate" "Means of Compensation (Dividend) Effect on Debt Serviceability Effect of Leverage Metrics
General Insights - CORRECT ANSWER -Dividend
-Analyst must adjust EBITDA for the drawings. Removing dividends reduces DSCR -Direct draw against retained earnings, thus decreasing equity and increasing leverage ratios accordingly -Dividends are a more tax effective way to get money out of the company than a salary and is more common" "Means of Compensation (Increase in Shareholder (S/H) Loan Asset) Effect on Debt Serviceability Effect of Leverage Metrics
General Insights - CORRECT ANSWER -Increase in Shareholder (S/H) Loan Asset
-EBITDA must be adjusted accordingly since the increased asset account is a cash outflow -Treated as 'intangible', since in practice, asset accounts are rarely paid back. Reduce TNW, increasing leverage ratios -Tax effective way to get cash out in the short term, but rarely paid back, and taxed as personal income in subsequent years" "Means of Compensation (Decrease in Shareholder (S/H) Loan Liability) Effect on Debt Serviceability Effect of Leverage Metrics
General Insights - CORRECT ANSWER -Decrease in Shareholder (S/H) Loan Liability
-Cash outflow, which is also typically removed from the EBITDA figure -If liability, reduces TL/TNW (positive). If postponed to the lender, it would decrease the equity position (net negative) -Requires a cash injection, originally classified as a S/H loan, and must be a balance in the S/H loan liability account." "Information & Document Collection When conducting financial analysis, you must ensure you have an extensive list of due diligence
documents - CORRECT ANSWER 1 Financial statements for the borrower - at least 3 years,
but preferably 5. 2 A clear understanding of the borrowing request, including a sources and uses of funds chart.
3 Corroboration around the value of the underlying asset, or assets being financed. 4 Personal financial information for any UBOs if a firm is not widely held or publicly traded 5 Financial projections, preferably in a live model format so you can work with the number provided by management." "A credit analyst generally can't derive a risk rating based on a projection model due to heavy regulations.
Financial Institutions: - CORRECT ANSWER Subject to heavy regulatory scrutiny
Regulators frequently audit a firm's commercial loan book Projection models require a lot of assumptions, making standardization difficult Take the borrower's most recent fiscal year-end and overlay those results with any proposed new debt."
"Credit Analysis Worksheet Summary - CORRECT ANSWER Answers"
"Conclusion - CORRECT ANSWER -Understand the components that go into financial
analysis -Calculate the key performance ratios that credit professionals use to assess a company's profitability and efficiency -Calculate the key financial ratios used to assess a company's liquidity, leverage, and coverage -Undertake a vertical analysis to determine profitability from the income statement and proportionality from the balance sheet -Undertake horizontal analysis to spot trends and analyze their meaning -Perform industry benchmarking"
"Vertical & Horizontal Analysis - CORRECT ANSWER Financial Analysis Overview"
"Financial analysis includes a number of steps to - CORRECT ANSWER get a complete picture
of the performance of a company. The starting point is the company's financial statements."
"Ratio analysis is great for - CORRECT ANSWER understanding the relationship between the
income statement and the balance sheet." "Performing Financial Analysis
Financial analysis must be undertaken with - CORRECT ANSWER an end-purpose in mind.
This will influence how you conduct and interpret your analysis."
"Credit Analyst - CORRECT ANSWER -Understand a company's overall financial health and
a borrower's credit risk -A company's ability to service credit obligations and how to mitigate loan loss in a default scenario"
"Cost of Good Sold - CORRECT ANSWER relates to direct labor and raw materials needed to
create the product or service that is being sold, as well as depreciation on manufacturing equipment used in production."
"Gross Profit - CORRECT ANSWER is what remains to fund the rest of the business' indirect
costs, after paying the costs that were directly related to what was sold."
"Indirect Costs - CORRECT ANSWER are those expenses required to run the business. The
most common are research & development, marketing, sales, and general & administration."
"Research & Development - CORRECT ANSWER represent costs required to keep up with or
stay ahead of the competition."
"Marketing & Sales - CORRECT ANSWER represent costs required to get products or services
out to customers (e.g., advertising)."
"Breakdown of income statement - CORRECT ANSWER Sales Revenue
Direct Costs Gross Profit Research & Development Marketing Sales Depreciation & Amortization General & Administration Income from Ops. Interest Inc./Exp. Taxes Net Income"
"General & Admin. - CORRECT ANSWER represent costs that cannot be allocated elsewhere
(e.g., legal & accounting salaries)."
"Depreciation & Amortization - CORRECT ANSWER unrelated to cost of sales also appear as
part of G&A."
"Operating Income/Profit - CORRECT ANSWER is used to pay the government, creditors, and
shareholders."
"Interest Inc./Exp. - CORRECT ANSWER may be generated or paid, depending on if the co.
invests in fixed income securities or takes on debt."
"Operating Profit is what is left to pay - CORRECT ANSWER interest to lenders, taxes to
governments, and dividends." "-EBIT is a common metric in valuation work and serves as an important part of the free cash flow to equity equation.
-EBIT may be less of a focus for many credit professionals because - CORRECT ANSWER it
fails to capture some important non-cash items."
"EBITDA Margin - CORRECT ANSWER = EBITDA / Revenue
Serves as a proxy for the operating cash flow of a business, as D&A are non-cash items."
"EBITDA is not actual cash flow, but - CORRECT ANSWER it accounts for the fact that
changes in working capital assets vary year to year. Improving collections cannot be relied upon indefinitely as future sources of cash."
"EBITDA more appropriately approximates operating cash flow in terms of - CORRECT
ANSWER the core operations of the business than other metrics. EBITDA is generally not
presented in financial results and must be manually calculated."
"Net Profit Margin = - CORRECT ANSWER Net Income / Sales
Net profit margin tells us how much net profit is generated for every dollar of revenue. This measure is not the best for comparing firms across jurisdictions, as tax rates can vary."
"Horizontal analysis is usually performed after - CORRECT ANSWER vertical analysis.
Horizontal analysis is known as trend analysis. -Performed by comparing results across months, quarters, or years. -It is best to compare results across multiple years. -Trends help inform projections & potential default risk."
"By analyzing historical trends, we are better able to - CORRECT ANSWER project future
performance and solvency." "Benefits of Horizontal Analysis
Horizontal analysis allows us to answer questions such as: - CORRECT ANSWER -Are
margins rising or falling? -Is performance improving or declining? -What is causing margins to rise or fall? -Elevator analysis is not useful on its own. -Use trend analysis to pinpoint areas for further investigation."
- Cross reference your client's ratios with the other 11 borrowers at their most recent year-ends to get an idea of the company's relative position
- Ratio calculations using internal data sources are more likely to be consistent"
"Third-party data providers (IBISWorld, CapitalIQ) - CORRECT ANSWER • Frequently have
large sample sizes from a wide variety of industries - are good comparable reference points
- Used by most financial institutions to enhance the credit decision-making process
- CFI's IBISWorld Fundamentals Course teaches about a third-party data provider, IBISWorld
- A six-month trial of IBISWorld and a two-month trial of CapitalIQ is available for all CFI Full- Immersion students"
"Working Capital Funding Gap - CORRECT ANSWER Cash out to cash in
AP - Place an order, Supplier delivery, pay the supplier (cash out) Inventory - Supplier delivery, pay the supplier (cash out), customer order AR - Customer order, Customer payment (cash in)"
"Liquidity Ratios - Financial Ratios - CORRECT ANSWER Liquidity"
"Liquidity ratios - CORRECT ANSWER Current ratio and quick ratio"
"Current ratio - CORRECT ANSWER (CA-prepaid expenses) / CL"
"Quick ratio - CORRECT ANSWER (CA - Inventory - prepaid expenses) / CL"
"Liquidity ratios
Remove assets that do not have any - CORRECT ANSWER tangible underlying cash value; the
most common example is prepaid expenses."
"When testing liquidity ratios, include - CORRECT ANSWER the current portion of any
proposed new credit facilities." "Leverage & Capital Structure
Ratio Analysis - CORRECT ANSWER Financial Ratios"
"Leverage expresses - CORRECT ANSWER the relationship between funding provided by
lenders and funding provided by shareholders" "Debt as a Funding Source
Sufficient access to cash - CORRECT ANSWER does not necessarily indicate that a company is
using that cash to acquire assets."
"Companies will frequently use an external source of financing to - CORRECT ANSWER fund
the acquisition of physical assets." "Debt as a Funding Source
There are a number of benefits to using - CORRECT ANSWER debt instead of equity as a
funding source. Easy to Obtain Optimal Timing Non Dilutive to Shareholders"
"Most borrowers in business and commercial banking will be - CORRECT ANSWER privately
held firms, predominantly made up of common shares."
"Equity - Preferred Shares - CORRECT ANSWER Estate Freezes Business Ownership
Planning Transfer of Ownership"
"Business Ownership Planning - CORRECT ANSWER • Intergenerational succession
planning"
"Transfer of Ownership - CORRECT ANSWER • Third-party equity as pref. shares
- Common in public markets"
"Different types of preferred shares have different impacts on a company. - CORRECT
ANSWER Cumulative preferred shares have a fixed rate of divided, accumulates if unpaid in
any period. 2 Participating preferred shares entitle preferred shareholders to additional profits. Convertible preferred shares provide the investor with the opportunity to convert into common 4 shares at a specified future date. A retractable preferred share is a preferred share that can be repaid at a specified price at a 5 maturity date."
"Cumulative preferred shares - CORRECT ANSWER have a fixed rate of dividend,
accumulates if unpaid in any period"
"Participating preferred shares - CORRECT ANSWER entitle preferred shareholders to
additional profits"
"Redeemable preferred shares - CORRECT ANSWER may be redeemed at the call of the
company or the investor."
"Convertible preferred shares - CORRECT ANSWER provide the investor with the
opportunity to convert into common shares at a specified future date."
"Debt to EBITDA is a - CORRECT ANSWER debt to cash flow metric. It requires the use of the
income statement. EBITDA is used as a proxy for cash flow rather than using actual cash flow. 1.) Easy to remember and calculate 2.) Popular and common across jurisdictions and industries 3.) Adjusts for different tax rates in different markets 4.) Provides a usable number even if there is enough leverage that interest payments drive net income and taxes down to zero. 5.) Provides a normalized cash flow metric that works across different capital structures"
"Debt to EBITDA = - CORRECT ANSWER = Interest Bearing Funded Debt (Current + Long-
Term Portions of Existing & Proposed New Credit Facilities) / EBITDA This number acts as a governor on total credit. Some lenders use a funded debt to EBITDA covenant of less than 3 to 3.5 to keep leverage in check."
"Debt to Adjusted EBITDA = - CORRECT ANSWER = Interest Bearing Funded Debt (Current +
Long-Term Portions of Existing & Proposed New Credit Facilities) / Adjusted EBITDA (Removes dividends and other cash outflows related to shareholder or related party loans if deemed non- discretionary) If shareholders expect that dividends will be paid out, it may be worth excluding dividends from EBITDA. Preferred shares may also factor into adjusted EBITDA if a fixed dividend payment is owed to these shareholders."
"Shareholder or related party loans are a - CORRECT ANSWER large consideration for credit
professionals in the private mid-market. Shareholder or related party loans are technically liabilities owed to the creditor. However, they are also near-equity, being at-risk funds put up by shareholders or executives of the company. -Treatment as a liability can materially impact a company -Affects smaller companies more, due to lack of equity from retained earnings -Banks & lenders will often request a subordination agreement (Causes these loans to be formally & legally subordinated behind the claims of the lender)" "Ratio Analysis Financial Ratios
Coverage - CORRECT ANSWER Coverage Ratios"
"Coverage represents - CORRECT ANSWER a company's ability to service or cover its
obligations to creditors. This is important if management decides to use debt in the company's capital structure"
"Coverage ratios represent the borrower's ability to service its - CORRECT ANSWER annual
debt responsibilities (interest and principal) using the cash it generates annually.
1.) Interest Coverage Ratio 2.) Debt Service Coverage Ratio (DSCR)"
"Interest Coverage Ratio - CORRECT ANSWER Primarily used when a borrower has little to
no principal obligations"
"Debt Service Coverage Ratio (DSCR) - CORRECT ANSWER Used when a company has
reducing/amortizing term debt (principal and interest payments) Most senior, secured lenders will work with many reducing credit facilities" "Loan Pricing
The credit spread is a direct function of the - CORRECT ANSWER borrower's level of default
risk and the nature of the loan itself. Is the loan reducing? Is the loan secured? How long is the loan's amortization? (Risk, Credit spread, All-in rate)"
"Fixed Rate Loan: - CORRECT ANSWER All-In Rate"
"Variable (Floating) Rate Loan: - CORRECT ANSWER Base Rate + Spread"
"As a commercial banker or credit analyst trying to win new business from a competitor, -
CORRECT ANSWER the client's interest rate or spread are usually outlined in the notes to
their financial statements." "Interest coverage (times interest earned) can be calculated a couple ways. This can make
benchmarking challenging as you must ensure consistency across the resources you use. -
CORRECT ANSWER EBITDA - Adds back non-cash expenses (D&A)
As a credit professional, you may wish to calculate an adjusted EBITDA figure to ensure you are measuring the most conservative ratios."
"Interest Coverage = - CORRECT ANSWER = (EBITDA - Non-discretionary Cash Outflows) /
Total Annual Interest Obligations (Existing Facilities & Proposed New Borrowings) How many times EBITDA can cover the firm's interest obligations" "Interest Coverage Ratio
Arriving at the interest amount may also require some adjustments. - CORRECT ANSWER 1
Use a test interest rate 2 Make assumptions about credit utilization Work off estimates, Use averages"
