CFA Level I · CFA Level I Exam

Credit Analysis for Corporate Issuers: formula sheet

Full chapter guide

Key formulas

Expected loss: EL = PD × LGD; PD is the probability of default over the period. LGD is the loss in money or as a percentage of exposure.
Loss given default: LGD = Exposure × (1 − Recovery rate); Use LGD% = 1 − recovery rate when exposure is 100%.
Expected loss in money: EL = PD × Exposure × (1 − Recovery rate); Combines the two formulas above. Exposure is the amount owed at default.
Recovery rate: Recovery rate = 1 − LGD%; Recovery is the share of the claim you get back, not of the price paid.
Credit risk components: Credit risk = default probability and loss severity; Probability of default is the likelihood of default. Loss severity is the size of loss if it happens.
Capacity: Capacity = ability to repay from cash flow; Assessed with industry analysis, competitive position and ratios such as debt/EBITDA and EBITDA/interest.
Collateral: Collateral = assets backing the debt; Drives recovery if default occurs, not the probability of default.
Covenants: Affirmative = must do; Negative = must not do; Both protect lenders. Negative covenants restrict actions such as extra debt or large dividends.
Character: Character = management quality and willingness to repay; Judged from governance, track record, strategy and incentives.
Common leverage and coverage ratios: Debt/EBITDA; EBITDA ÷ interest expense; FFO ÷ total debt; Higher leverage ratios mean more risk. Higher coverage ratios mean less risk.
Debt/EBITDA: Debt/EBITDA = Total debt ÷ EBITDA; Leverage. Lower means stronger credit. It is roughly the number of years of EBITDA needed to repay debt.
FFO/Debt: FFO/Debt = FFO ÷ Total debt; Leverage on a cash-flow basis. Higher means stronger credit. FFO = net income + depreciation, amortization and other non-cash items.
EBITDA interest coverage: EBITDA/Interest = EBITDA ÷ Interest expense; Coverage. Higher is better. It is more generous than EBIT coverage.
EBIT interest coverage: EBIT/Interest = EBIT ÷ Interest expense; Coverage. Stricter than EBITDA coverage because depreciation is deducted.
Debt/Capital: Debt/Capital = Total debt ÷ (Total debt + Equity); Leverage on a balance sheet basis. Lower is better. Equity is usually book value.
Free cash flow/Debt: FCF/Debt = (CFO − Capex) ÷ Total debt; Higher is better. It captures the effect of capital spending that EBITDA ignores.
EBITDA to EBIT link: EBITDA = EBIT + Depreciation and amortization; Use this to convert between the two when only one is given.
Credit spread: Credit spread = Yield on credit-risky bond − Yield on benchmark bond of same maturity; Quote in basis points. 1 bp = 0.01%. Use the same maturity and currency.
Expected loss: Expected loss = Probability of default × Loss given default; Loss given default = 1 − recovery rate. Spreads must at least cover expected loss and add a risk premium.
Approximate price change from spread change: %ΔPrice ≈ −Modified duration × ΔSpread; Holds for a small change in spread with benchmark yield unchanged. Widening lowers price.
Investment grade boundary: Investment grade: BBB- / Baa3 and above. High yield: BB+ / Ba1 and below; Know both scales: S&P and Fitch vs Moody's.
Typical priority of claims: First lien secured > second lien secured > senior unsecured > subordinated > preferred equity > common equity; Higher in the list is paid first. Same-level claims are pari passu.
Loss severity: Loss severity = 1 − Recovery rate; Recovery rate is a percentage of the claim, including accrued interest, that is recovered.
Expected loss: Expected loss = Probability of default × Loss severity; Use loss given default in the same units as the claim. Both inputs must cover the same horizon.
Pari passu sharing: Class recovery rate = Value available to the class ÷ Total claims in the class; Every holder in the class gets the same percentage. Multiply this rate by each claim's size to get the amount, so recovery is pro rata to claim size.
Recovery amount: Recovery amount = Claim × Recovery rate; Claim usually means face value plus accrued interest at default.
Debt service coverage (revenue bonds): DSCR = Net revenue available for debt service ÷ Debt service; Above 1 means revenue covers payments. Higher means more cushion.
Sovereign debt burden: Debt-to-GDP = Government debt ÷ GDP; Higher ratios usually signal weaker capacity, though the currency and maturity of the debt also matter.
Leverage and coverage (high-yield): Debt ÷ EBITDA and EBITDA ÷ Interest expense; Higher leverage and lower coverage mean greater default risk.
Expected loss: Expected loss = Probability of default × Loss given default; Recovery priority lowers loss given default for senior creditors.

Quick revision

Credit risk has two parts: probability of default and loss severity.
Expected loss = probability of default × loss given default.
Loss given default = 1 - recovery rate.
The four Cs: capacity, collateral, covenants, character.
Stronger credit: lower leverage, higher interest coverage, steadier cash flow.
Credit spread is the extra yield over a benchmark for taking credit risk.
Wider spreads push bond prices down; tighter spreads push them up.
Senior secured claims generally recover more than unsecured or subordinated claims.
Ratings below investment grade are high-yield, with higher default risk.
High-yield analysis puts more weight on liquidity, covenants and recovery.
Sovereign analysis looks at both ability and willingness to pay.
Rating agencies give opinions; they are not a guarantee, so do your own analysis.

Common mistakes

Using the recovery rate as the loss severity. Fix: Always compute LGD% = 1 − recovery rate before multiplying by PD.
Treating a high rating as meaning low loss severity. Fix: Remember ratings mainly address default probability. Loss severity depends on seniority, collateral and the recovery outlook.
Treating collateral as the main source of repayment. Fix: Remember that cash flow (capacity) is the primary source of repayment. Collateral is the fallback and affects recovery.
Classifying a restriction on extra debt as an affirmative covenant. Fix: Ask whether the clause prohibits an action. If it limits or forbids something, it is negative.
Treating a higher debt/EBITDA as stronger credit. Fix: Remember debt/EBITDA is years of earnings needed to repay debt. More years means more risk.
Using EBITDA when the question asks for EBIT coverage. Fix: Read the numerator in the question. If only EBITDA is given, subtract depreciation and amortization to get EBIT.
Saying spreads narrow in a recession Fix: Government yields may fall in a recession, but credit spreads widen because default risk and risk aversion rise.
Treating BBB+ or Baa1 as high yield Fix: Investment grade runs down to BBB- or Baa3. High yield starts at BB+ or Ba1.
Assuming a bond with a longer or shorter maturity ranks differently from another bond of the same class. Fix: In default, ranking depends on the legal class (secured, senior, subordinated), not maturity. Same-class claims are pari passu.
Treating pari passu as meaning equal dollar amounts. Fix: Pari passu means equal priority. Each holder gets the same percentage of its claim, so payouts are proportional to claim size.

Exam tips

Questions are three-option items. For numeric ones, the wrong options often reflect a missed step, so compute carefully and compare.
Expect concept items that split credit risk into probability of default and loss severity. Link PD to rating and LGD to seniority and collateral.
Do the 1 − recovery step first and write it down. It is the most common lost mark.
Remember that expected loss is a probability-weighted average, not what you will actually lose.
Numerical options go from smallest to largest, so a quick estimate can remove one option.
Questions often give one clue and ask which C it belongs to. Classify first, then read the options.
Know the affirmative and negative examples by heart, since covenant questions are common and easy to score on.
Remember that collateral mainly affects loss given default, while capacity affects probability of default.