Risk Management and Credit Assessment
Core concepts
Credit assessment evaluates a borrower's capacity and willingness to repay. Candidates must understand the classic credit framework-character, capacity, capital, collateral, and conditions-and the quantitative tools: leverage ratios, coverage ratios, liquidity, and cash flow adequacy. Know how lenders set covenants, assess default probability qualitatively, and weigh secured versus unsecured exposure. Risk management concepts include diversification, exposure limits, and the relationship between risk and return.
Traps to watch
- Capacity vs. collateral: Strong collateral does not substitute for repayment capacity; questions often test this distinction.
- Coverage vs. leverage: A firm can carry high debt but still service it if cash flow is stable-evaluate both.
- Covenant mechanics: Breaching a covenant can trigger acceleration even without missed payments.
- Procyclical metrics: Ratios computed at peak earnings may overstate repayment ability.
Rule of thumb
Stress-test debt service: compare free cash flow to total debt service (interest plus scheduled principal). A coverage cushion below 1.25× is generally thin. Worked example: free cash flow $250,000, annual interest $120,000, scheduled principal $80,000. Debt service coverage = 250,000 ÷ 200,000 = 1.25×-adequate but with little margin for deterioration, warranting tighter covenants or additional collateral.