Financial Analysis and Risk Assessment
Domain 3 - Financial Analysis and Risk Assessment
Tests reading financial statements for repayment capacity, quantifying risk with ratios and scores, and forming a defensible credit recommendation.
Core rules
- Four ratio families: liquidity (current, quick), leverage (debt/EBITDA, debt/equity), coverage (EBIT/interest), and efficiency (DSO, inventory days). Trends and peer comparisons matter more than one year's value.
- Cash flow is the repayment source. EBITDA is not cash flow; subtract capex, taxes, and working-capital swings. Free cash flow = CFO − capex.
- Quality of earnings: revenue recognition, one-time gains, capitalized costs, related-party transactions, and off-balance-sheet obligations.
- Risk rating combines quantitative score, industry outlook, collateral, guarantor strength, and payment history. Document override rationale.
- Altman Z' for private manufacturers: Z' = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5, with zones above 2.90 safe and below 1.23 distress.
Worked example
A private manufacturer has working capital/total assets 0.20, retained earnings/total assets 0.15, EBIT/total assets 0.12, book equity/total liabilities 0.60, and sales/total assets 1.40. Z' = 0.717(0.20) + 0.847(0.15) + 3.107(0.12) + 0.420(0.60) + 0.998(1.40) = 0.143 + 0.127 + 0.373 + 0.252 + 1.397 = 2.292. That is in the grey zone: not distress, not safe. The recommendation should cap the limit, require quarterly financials, and set a covenant tied to debt/EBITDA.
Traps
- Using year-end numbers only; window dressing inflates liquidity.
- Comparing ratios across industries without adjustment (asset-heavy vs. service).
- Treating a high Z score as a guarantee; scores miss fraud, customer concentration, and covenant breaches.