Reading: Fundamentals of Credit Analysis

Learning Outcomes as per CFA Institute

a. Describe credit risk and credit-related risks affecting corporate bonds.
b. Describe default probability and loss severity as components of credit risk.
c. Describe seniority rankings of corporate debt and explain the potential violation of the priority of
claims in a bankruptcy proceeding.
d. Compare and contrast corporate issuer credit ratings and issue credit ratings and describe the
rating agency practice of “notching”.
e. Explain risks in relying on ratings from credit rating agencies.
f. Explain the four Cs (Capacity, Collateral, Covenants, and Character) of traditional credit analysis.
g. Calculate and interpret financial ratios used in credit analysis.
h. Evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial
ratios of the issuer and the industry.
i. Describe macroeconomic, market, and issuer-specific factors that influence the level and volatility
of yield spreads.
j. Explain special considerations when evaluating the credit of high-yield, sovereign, and non-
sovereign government debt issuers and issues.

1. [LOS a, b] The risk that a bond’s creditworthiness declines is best described by:
A. credit migration risk.
B. market liquidity risk.
C. spread widening risk.

2. [LOS a, b] Stedsmart Ltd and Fignermo Ltd are alike with respect to financial and operating
characteristics, except that Stedsmart Ltd has less publicly traded debt outstanding than Fignermo
Ltd. Stedsmart Ltd is most likely to have:
A. no market liquidity risk.
B. lower market liquidity risk.
C. higher market liquidity risk.

3. [LOS c] In the event of default, the recovery rate of which of the following bonds would most likely
be the highest?
A. First mortgage debt
B. Senior unsecured debt
C. Junior subordinate debt

4. [LOS c] During bankruptcy proceedings of a firm, the priority of claims was not strictly adhered to.
Which of the following is the least likely explanation for this outcome?
A. Senior creditors compromised.
B. The value of secured assets was less than the amount of the claims.
C. A judge’s order resulted in actual claims not adhering to strict priority of claims.

5. [LOS d, e] A fixed-income analyst is least likely to conduct an independent analysis of credit risk
because credit rating agencies:
A. may at times mis-rate issues.
B. often lag the market in pricing credit risk.
C. cannot foresee future debt-financed acquisitions.
 Fundamentals of Credit Analysis

6. [LOS f, g, h] If goodwill makes up a large percentage of a company’s total assets, this most likely
indicates that:
A. the company has low free cash flow before dividends.
B. there is a low likelihood that the market price of the company’s common stock is below book
value.
C. a large percentage of the company’s assets are not of high quality.

7. [LOS f, g, h] In order to analyze the collateral of a company, a credit analyst should assess the:
A. cash flows of the company.
B. soundness of management’s strategy.
C. value of the company’s assets in relation to the level of debt.

8. [LOS f, g, h] In order to determine the capacity of a company, it would be most appropriate to

analyze the:
A. company’s strategy.
B. growth prospects of the industry.
C. aggressiveness of the company’s accounting policies.

9. [LOS f, g, h] A credit analyst is evaluating the credit worthiness of three companies: a construction
company, a travel and tourism company, and a beverage company. Both the construction and
travel and tourism companies are cyclical, whereas the beverage company is non-cyclical. The
construction company has the highest debt level of the three companies. The highest credit risk
is most likely exhibited by the:
A. construction company.
B. beverage company.
C. travel and tourism company.

10. [LOS f, g, h] Based on the information provided in Exhibit 1, the EBITDA interest coverage ratio of
Adidas AG is closest to:
A. 16.02x.
B. 23.34x.
C. 37.98x.

11. [LOS f, g, h] The following information is from the annual report of Adidas AG for December 2019:
 Depreciation and amortization: €1,214 million

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 Total assets: €20,640 million

 Total debt: €4,364 million
 Shareholders’ equity: €7,058 million
The debt/capital of Adidas AG is closest to:
A. 21.14%.
B. 38.21%.
C. 61.83%.

12. [LOS f, g, h] Funds from operations (FFO) of Pay Handle Ltd (a fictitious company) increased in
20X1. In 20X1, the total debt of the company remained unchanged while additional common
shares were issued. Pay Handle Ltd’s ability to service its debt in 20X1, as compared to 20X0, most
likely:
A. improved.
B. worsened.
C. remained the same.

13. [LOS f, g, h] Based on the information in Exhibit 2, GZ Group’s (a hypothetical company) credit risk
is most likely:
A. lower than the industry.
B. higher than the industry.
C. the same as the industry.

14. [LOS f, g, h] Based on the information in Exhibit 3, the credit rating of DCM Group (a hypothetical
company in the European food & beverage sector) is most likely:
A. lower than AB plc.
B. higher than AB plc.
C. the same as AB plc.

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15. [LOS i] Holding all other factors constant, the most likely effect of low demand and heavy new
issue supply on bond yield spreads is that yield spreads will:
A. widen.
B. tighten.
C. not be affected.

16. [LOS a, b] Credit risk of a corporate bond is best described as the:

A. risk that an issuer’s creditworthiness deteriorates.
B. probability that the issuer fails to make full and timely payments.
C. risk of loss resulting from the issuer failing to make full and timely payments.

17. [LOS a, b] The risk that the price at which investors can actually transact differs from the quoted
price in the market is called:
A. spread risk.
B. credit migration risk.
C. market liquidity risk.

18. [LOS a, b] Loss severity is best described as the:

A. default probability multiplied by the loss given default.
B. portion of a bond’s value recovered by bondholders in the event of default.
C. portion of a bond’s value, including unpaid interest, an investor loses in the event of default.

19. [LOS a, b] The two components of credit risk are default probability and:
A. spread risk.
B. loss severity.
C. market liquidity risk.

20. [LOS a, b] For a high-quality debt issuer with a large amount of publicly traded debt, bond investors
tend to devote most effort to assessing the issuer’s:
A. default risk.
B. loss severity.
C. market liquidity risk.

21. [LOS a, b] The expected loss for a given debt instrument is estimated as the product of default
probability and:
A. (1 + Recovery rate).
B. (1 – Recovery rate).
C. 1/(1 + Recovery rate).

22. [LOS c] The priority of claims for senior subordinated debt is:
A. lower than for senior unsecured debt.
B. the same as for senior unsecured debt.
C. higher than for senior unsecured debt.

23. [LOS c] A senior unsecured credit instrument holds a higher priority of claims than one ranked as:
A. mortgage debt.
B. second lien loan.
C. senior subordinated.

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24. [LOS c] In a bankruptcy proceeding, when the absolute priority of claims is enforced:
A. senior subordinated creditors rank above second lien holders.
B. preferred equity shareholders rank above unsecured creditors.
C. creditors with a secured claim have the first right to the value of that specific property.

25. [LOS c] In the event of default, which of the following is most likely to have the highest recovery
rate?
A. Second lien
B. Senior unsecured
C. Senior subordinated

26. [LOS d, e] The process of moving credit ratings of different issues up or down from the issuer rating
in response to different payment priorities is best described as:
A. notching.
B. structural subordination.
C. cross-default provisions.

27. [LOS d, e] The factor considered by rating agencies when a corporation has debt at both its parent
holding company and operating subsidiaries is best referred to as:
A. credit migration risk.
B. corporate family rating.
C. structural subordination.

28. [LOS d, e] Which type of security is most likely to have the same rating as the issuer?
A. Preferred stock
B. Senior secured bond
C. Senior unsecured bond

29. [LOS c] Which of the following corporate debt instruments has the highest seniority ranking?
A. Second lien
B. Senior unsecured
C. Senior subordinated

30. [LOS d, e] An issuer credit rating usually applies to a company’s:

A. secured debt.
B. subordinated debt.
C. senior unsecured debt.

31. [LOS d, e] The rating agency process whereby the credit ratings on issues are moved up or down
from the issuer rating best describes:
A. notching.
B. pari passu ranking.
C. cross-default provisions.

32. [LOS d, e] The notching adjustment for corporate bonds rated Aa2/AA is most likely:
A. larger than the notching adjustment for corporate bonds rated B2/B.
B. the same as the notching adjustment for corporate bonds rated B2/B.
C. smaller than the notching adjustment for corporate bonds rated B2/B.

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33. [LOS d, e] Which of the following statements about credit ratings is most accurate?
A. Credit ratings can migrate over time.
B. Changes in bond credit ratings precede changes in bond prices.
C. Credit ratings are focused on expected loss rather than risk of default.

34. [LOS f, g, h] Which industry characteristic most likely has a positive effect on a company’s ability
to service debt?
A. Low barriers to entry in the industry
B. High number of suppliers to the industry
C. Broadly dispersed market share among large number of companies in the industry

35. [LOS f, g, h] When determining the capacity of a borrower to service debt, a credit analyst should
begin with an examination of:
A. industry structure.
B. industry fundamentals.
C. company fundamentals.

36. [LOS f, g, h] Which of the following accounting issues should mostly likely be considered a
character warning flag in credit analysis?
A. Expensing items immediately
B. Changing auditors infrequently
C. Significant off-balance-sheet financing

37. [LOS f, g, h] In credit analysis, capacity is best described as the:

A. quality of management.
B. ability of the borrower to make its debt payments on time.
C. quality and value of the assets supporting an issuer’s indebtedness.

38. [LOS f, g, h] Among the four Cs of credit analysis, the recognition of revenue prematurely most
likely reflects a company’s:
A. character.
B. covenants.
C. collateral.

Use the following Exhibit for Questions 39 and 40

39. [LOS f, g, h] Based on only the leverage ratios in Exhibit 4, the company with the highest credit risk
is:
A. Company A.
B. Company B.

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C. Company C.

40. [LOS f, g, h] Based on only the coverage ratios in Exhibit 4, the company with the highest credit
quality is:
A. Company A.
B. Company B.
C. Company C.

Use the following Exhibits for Questions 41 and 42

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41. [LOS f, g, h] Based on Exhibits 5–7, in comparison to Company X, Company Y has a higher:
A. debt/capital.
B. debt/EBITDA.
C. free cash flow after dividends/debt.

42. [LOS f, g, h] Based on Exhibits 5–7, in comparison to Company Y, Company X has greater:
A. leverage.
B. interest coverage.
C. operating profit margin.

43. [LOS i] Credit yield spreads most likely widen in response to:
A. high demand for bonds.
B. weak performance of equities.
C. strengthening economic conditions.

44. [LOS i] The factor that most likely results in corporate credit spreads widening is:
A. an improving credit cycle.
B. weakening economic conditions.
C. a period of high demand for bonds.

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45. [LOS i] Credit spreads are most likely to widen:

A. in a strengthening economy.
B. as the credit cycle improves.
C. in periods of heavy new issue supply and low borrower demand.

46. [LOS j] Which of the following factors in credit analysis is more important for general obligation
non-sovereign government debt than for sovereign debt?
A. Per capita income
B. Power to levy and collect taxes
C. Requirement to balance an operating budget

47. [LOS j] In contrast to high-yield credit analysis, investment-grade analysis is more likely to rely on:
A. spread risk.
B. an assessment of bank credit facilities.
C. matching of liquidity sources to upcoming debt maturities.

48. [LOS j] Which of the following factors would best justify a decision to avoid investing in a country’s
sovereign debt?
A. Freely floating currency
B. A population that is not growing
C. Suitable checks and balances in policymaking

49. [LOS d] In assigning credit ratings, the practice of notching by the rating agencies is least likely
used to quantify the:
A. probability of default.
B. priority of payment in the event of default.
C. potential severity of loss in the event of default.

50. [LOS h] A credit analyst observes the following information for Zeta Corp. and its industry.
Particulars Zeta Corp. Industry Median
Return on capital (%) 19.0% 20.0%
Total debt/Total capital (%) 42.0% 15.5%
FFO/Total debt (%) 45.3% 40.0%
Total debt/EBITDA (x) 3.5x 1.2x
EBITDA interest coverage (x) 4.0x 7.5x
Based on this information, it is most likely that the credit risk of Zeta Corp. is:
A. below its industry peers.
B. similar to its industry peers.
C. above its industry peers.

51. [LOS i] [to be covered under reading: Understanding Fixed-Income Risk and Return] The Delfain
Corporation reported a significant improvement in profitability that was followed by a material
upgrade in its credit rating. The market responded by immediately requiring a 100-basis point
narrower spread to Gilts on Delfain’s 8-year bond. If the bond’s modified duration is 6.0 and its
convexity is 55.0, the return impact of this change is closest to:
A. 6.28%.
B. –5.73%.
C. 7.10%.

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52. [LOS j] Compared with investment-grade bonds, the spread movements on high-yield bonds are
influenced:
A. less by interest rate changes and exhibit a greater correlation with movements in equity
markets.
B. less by interest rate changes and exhibit a lower correlation with movements in equity
markets.
C. more by interest rate changes and exhibit a greater correlation with movements in equity
markets.

53. [LOS c] The Zera Company has borrowed capital by issuing a number of different securities. Which
of the following most likely ranks the highest with respect to priority of payments?
A. Subordinate loan
B. Second lien debt
C. Senior unsecured bond

54. [LOS e] A problem for bond investors relying on credit ratings as a basis for buy and sell decisions
is that credit ratings:
A. are historically inaccurate.
B. can badly lag changes in bond prices.
C. are less reliable for investment-grade bonds.

55. [LOS g] The following table shows selected data from a company’s cash flow statement:
Particulars 2018
Net income $516
Depreciation $88
Amortization $66
Change in working capital -$44
Additions to property and equipment -$62
Proceeds from sale of property and equipment $8
The company’s free cash flow before dividends is closest to:
A. 572.
B. 660.
C. 696.

56. [LOS g] Selected data for three companies are provided in the table below:
Particulars Company A Company B Company C
Total debt ($mn) 1,125 1,360 1,562
EBITDA ($mn) 590 680 750
Interest expense ($mn) 71 60 63
Which company’s leverage contributes most adversely to its credit risk?
A. Company A
B. Company B
C. Company C

57. [LOS j] High-yield bond analysis differs from investment-grade bond analysis in that high-yield:
A. analysis is less likely to focus on an issuer’s liquidity.
B. covenant analysis is more important than for investment-grade bonds.
C. bond prices are more affected by interest rate changes than higher-quality bonds.

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58. [LOS g] Below is a company’s operating statement:

Using the more conservative interest coverage ratio measure, the interest coverage ratio is closest
to:
A. 24.89×
B. 35.78×
C. 40.06×

59. [LOS i] Credit spreads are most likely to narrow during:

A. economic contractions.
B. a period of flight to quality.
C. economic expansions.

60. [LOS f] Which of the following is least likely a component of the “Four Cs of Credit Analysis”
framework?
A. Covenants
B. Competition
C. Collateral

61. [LOS c] Which bonds most likely rank the highest with respect to priority of claims?
A. Subordinated debt
B. Second lien debt
C. Senior unsecured bond

62. [LOS f] Using the “Four Cs of Credit Analysis” framework, which of the following is the least likely
factor to be considered under the category of “capacity”?
A. Level of competition
B. Industry fundamentals
C. History of fraud or malfeasance

Solutions
1. A is correct. Credit migration risk or downgrade risk refers to the risk that a bond issuer’s
creditworthiness may deteriorate or migrate lower. The result is that investors view the risk of
default to be higher, causing the spread on the issuer’s bonds to widen.

2. C is correct. Market liquidity risk refers to the risk that the price at which investors transact may
be different from the price indicated in the market. Market liquidity risk is increased by (1) less
debt outstanding and/or (2) a lower issue credit rating. Because Stedsmart Ltd is comparable to

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Fignermo Ltd except for less publicly traded debt outstanding, it should have higher market
liquidity risk.

3. A is correct. First mortgage debt is senior secured debt and has the highest priority of claims. First
mortgage debt also has the highest expected recovery rate. First mortgage debt refers to the
pledge of specific property. Neither senior unsecured nor junior subordinate debt has any claims
on specific assets.

4. B is correct. Whether or not secured assets are sufficient for the claims against them does not
influence priority of claims. Any deficiency between pledged assets and the claims against them
becomes senior unsecured debt and still adheres to the guidelines of priority of claims.

5. C is correct. Both analysts and rating agencies have difficulty foreseeing future debt-financed
acquisitions.

6. C is correct. Goodwill is viewed as a lower quality asset compared with tangible assets that can be
sold and more easily converted into cash.

7. C is correct. The value of assets in relation to the level of debt is important to assess the collateral
of the company—that is, the quality and value of the assets that support the debt levels of the
company.

8. B is correct. The growth prospects of the industry provide the analyst insight regarding the
capacity of the company.

9. A is correct. The construction company is both highly leveraged, which increases credit risk, and
in a highly cyclical industry, which results in more volatile earnings.

10. B is correct. The interest expense is €166 million and EBITDA = Operating profit + Depreciation and
amortization = €2,660 + 1,214 million = €3,874 million. EBITDA interest coverage =
EBITDA/Interest expense = 3,874/166 = 23.34 times.

11. B is correct. Total debt is €4,364 million with Total capital = Total debt + Shareholders’ equity =
€4,364 + 7,058 = €11,422 million. The Debt/Capital = 4,364/11,422 = 38.21%.

12. A is correct. If the debt of the company remained unchanged but FFO increased, more cash was
available to service debt compared to the previous year. Additionally, debt/capital improved,
which implies that the ability of Pay Handle Ltd to service their debt also improved.

13. A is correct. Based on four of the five credit ratios, GZ Group’s credit quality is superior to that of
the industry.

14. A is correct. DCM Group has more financial leverage and less interest coverage than AB plc, which
implies greater credit risk.

15. A is correct. Low demand implies wider yield spreads, and heavy supply widens spreads even
further.

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16. C is correct. Credit risk is the risk of loss resulting from the borrower failing to make full and timely
payments of interest and/or principal.

17. C is correct. Market liquidity risk is the risk that the price at which investors can actually transact—
buying or selling—may differ from the price indicated in the market.

18. C is correct. Loss severity is the portion of a bond’s value (including unpaid interest) an investor
loses in the event of default.

19. B is correct. The two components of credit risk are default probability and loss severity. In the
event of default, loss severity is the portion of a bond’s value (including unpaid interest) an
investor loses. A and C are incorrect because spread and market liquidity risk are credit-related
risks, not components of credit risk.

20. A is correct. Credit risk has two components: default risk and loss severity. Because default risk is
quite low for most high-quality debt issuers, bond investors tend to focus more on this likelihood
and less on the potential loss severity.

21. B is correct. The expected loss for a given debt instrument is the default probability multiplied by
the loss severity given default. The loss severity is often expressed as (1 – Recovery rate).

22. A is correct. Senior subordinated debt is ranked lower than senior unsecured debt and thus has a
lower priority of payment.

23. C is correct. The highest-ranked unsecured debt is senior unsecured debt. Lower-ranked debt
includes senior subordinated debt. A and B are incorrect because mortgage debt and second lien
loans are secured and higher ranked.

24. C is correct. According to the absolute priority of claims, in the event of bankruptcy, creditors with
a secured claim have the right to the value of that specific property before any other claim.

25. A is correct. A second lien has a secured interest in the pledged assets. Second lien debt ranks
higher in priority of payment than senior unsecured and senior subordinated debt and thus would
most likely have a higher recovery rate.

26. A is correct. Notching is the process for moving ratings up or down relative to the issuer rating
when rating agencies consider secondary factors, such as priority of claims in the event of a default
and the potential loss severity.

27. C is correct. Structural subordination can arise when a corporation with a holding company
structure has debt at both its parent holding company and operating subsidiaries. Debt at the
operating subsidiaries is serviced by the cash flow and assets of the subsidiaries before funds are
passed to the parent holding company.

28. C is correct. The issuer credit rating usually applies to its senior unsecured debt.

29. A is correct. Second lien debt is secured debt, which is senior to unsecured debt and to
subordinated debt.

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30. C is correct. An issuer credit rating usually applies to its senior unsecured debt.

31. A is correct. Recognizing different payment priorities, and thus the potential for higher (or lower)
loss severity in the event of default, the rating agencies have adopted a notching process whereby
their credit ratings on issues can be moved up or down from the issuer rating (senior unsecured).

32. C is correct. As a general rule, the higher the senior unsecured rating, the smaller the notching
adjustment. Thus, for corporate bonds rated Aa2/AA, the rating agencies will typically apply
smaller rating adjustments, or notches, to the related issue.

33. A is correct. Credit migration is the risk that a bond issuer’s creditworthiness deteriorates, or
migrates lower. Over time, credit ratings can migrate significantly from what they were at the time
a bond was issued. An investor should not assume that an issuer’s credit rating will remain the
same from the time of purchase through the entire holding period.

34. B is correct. An industry with a high number of suppliers reduces the suppliers’ negotiating power,
thus helping companies control expenses and aiding in the servicing of debt.

35. A is correct. Credit analysis starts with industry structure—for example, by looking at the major
forces of competition, followed by an analysis of industry fundamentals—and then turns to
examination of the specific issuer.

36. C is correct. Credit analysts can make judgments about management’s character by evaluating the
use of aggressive accounting policies, such as timing revenue recognition. This activity is a
potential warning flag for other behaviors or actions that may adversely affect an issuer’s
creditworthiness.

37. B is correct. Capacity refers to the ability of a borrower to service its debt. Capacity is determined
through credit analysis of an issuer’s industry and of the specific issuer.

38. A is correct. Credit analysts can make judgments about management’s character in a number of
ways, including by observing its use of aggressive accounting policies and/or tax strategies. An
example of this aggressiveness is recognizing revenue prematurely.

39. C is correct. Debt/capital and debt/EBITDA are used to assess a company’s leverage. Higher
leverage ratios indicate more leverage and thus higher credit risk. Company C’s debt/capital
(46.3%) and debt/EBITDA (2.5×) are higher than those for Companies A and B.

40. B is correct. The EBITDA/interest expense and EBIT/interest expense are coverage ratios. Coverage
ratios measure an issuer’s ability to meet its interest payments. A higher ratio indicates better
credit quality. Company B’s EBITDA/interest expense (62.4×) and EBIT/interest expense (58.2×)
are higher than those for Companies A and C.

41. C is correct because Company Y has a higher ratio of free cash flow after dividends to debt than
Company X, not lower, as shown in the following table.

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Free cash flow after dividends as a % of debt =

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42. A is correct. Compared with Company Y, based on both their debt/capital and their ratios of free
cash flow after dividends to debt, which are measures of leverage commonly used in credit
analysis, Company X is more highly leveraged, as shown in the following table.

43. B is correct. In weak financial markets, including weak markets for equities, credit spreads will
widen.

44. B is correct. Weakening economic conditions will push investors to desire a greater risk premium
and drive overall credit spreads wider.

45. C is correct. In periods of heavy new issue supply, credit spreads will widen if demand is
insufficient.

46. C is correct. Non-sovereign governments typically must balance their operating budgets and lack
the discretion to use monetary policy as many sovereigns can.

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47. A is correct. Most investors in investment-grade debt focus on spread risk—that is, the effect of
changes in spreads on prices and returns—while in high-yield analysis, the focus on default risk is
relatively greater.

48. B is correct. Among the most important considerations in sovereign credit analysis is growth and
age distribution of population. A relatively young and growing population contributes to growth
in GDP and an expanding tax base and relies less on social services, pensions, and health care
relative to an older population.

49. A is correct. For the rating agencies, the main factor motivating the assignment of a rating is the
probability of default. Notching is most likely to be used to address secondary factors such as the
priority of payment in the event of default and the potential severity of loss in the event of default.
These secondary factors are accounted for via notching the issue’s rating up or down relative to
the issuer’s rating.

50. C is correct. The company has a similar return on capital, but it has significantly higher leverage as
well as a lower EBITDA interest coverage ratio than its industry peers. It is likely that the company’s
credit risk will be above its industry peers.

51. A is correct. The return impact of a 60 bps fall in the bond’s yield can be computed as:
Return impact ≈ –(MDur × ΔSpread) + ½Cvx × (𝛥𝑆𝑝𝑟𝑒𝑎𝑑)
Return impact ≈ –(6.0 × –0.01) + ½(55.0) × (– 0.01) = 6.28%

52. A is correct. High-yield bonds can be thought of as a hybrid between investment-grade bonds and
equity securities. Their spread movements are less influenced by interest rate changes than are
investment-grade bonds, and they exhibit greater correlation with movements in equity markets.

53. B is correct. Second lien debt is secured debt. It has a secured interest in the pledged assets and
ranks higher than all other unsecured debts.

54. B is correct. In response to changes in perceived creditworthiness, bond prices and credit spreads
often move more quickly than rating agencies change their ratings up or down. Bond prices and
relative valuations can move every day, whereas bond ratings do not change very often. Thus,
bond investors who wait for rating agencies to change their ratings before making buy and sell
decisions in their portfolios may be at risk of underperforming other investors who make portfolio
decisions in advance of rating agency changes.

55. B is correct. Free cash flow before dividends is calculated as net income (excluding non-recurring
charges) plus depreciation and amortization minus the increase (plus the decrease) in working
capital minus capital expenditures. It is, depending on the treatment of dividends and interest in
the cash flow statement, approximated by the cash flow from operating activities minus capital
expenditures.
FCF = 516 + 88 + 66 + 44 – 62 + 8 = 660.

56. C is correct. The only leverage ratio that can be calculated given the data provided is the debt-to-
EBITDA ratio. Company C has the highest debt-to-EBITDA ratio of the three companies presented.
A higher ratio indicates more leverage and thus higher credit risk. Company C also has the highest

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coverage ratio (EBITDA/interest expense) of the three companies, which would indicate lower
credit risk, but the question is confined to analyzing leverage ratios only.
Company A: 1,125/590 = 1.9×
Company B: 1,360/680 = 2.0×
Company C: 1,562/750 = 2.08×

57. B is correct. Covenant analysis is especially important for high-yield credits because of their
reduced margin of safety. Covenants are meant to protect creditors, and high-yield bonds are
typically issued by companies with weak business profiles, which makes their risk of default higher
relative to investment-grade bonds, which are typically issued by companies with strong business
prospects. The increased likelihood of default for high-yield bonds relative to investment-grade
bonds makes covenant analysis more important for high-yield investors compared with
investment-grade investors.

58. B is correct. EBIT/interest expense, as opposed to EBITDA/interest expense, is the more

conservative interest coverage ratio measure because it deducts non-cash expenses, such as
depreciation and amortization, when measuring the issuer’s ability to “cover” interest payments.
Because EBIT does not include depreciation and amortization, the interest coverage will appear
lower than if an analyst chose to include those items, such as with EBITDA.
$3,685/$103 = 35.78×.

59. C is correct. Credit spreads narrow during economic expansions and widen during economic
contractions. During an economic expansion, corporate revenues and cash flows rise, making it
easier for corporations to service their debt, and investors purchase corporates instead of
Treasuries, causing spreads to narrow.

60. B is correct. The “Four Cs of Credit Analysis” framework includes capacity, collateral, covenants,
and character. Competition is not one of the components.

61. B is correct. Second lien debt has a secured interest in the pledged assets and ranks higher than
the unsecured debt, such as senior unsecured bonds and subordinated debt.

62. C is correct. Any history of fraud or malfeasance is a major warning flag to credit analysts under
the category of “Character.”

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