FRM Part II · FRM Exam Part II · Credit Risk Management
A credit analyst reviews a manufacturer applying for a five-year term loan. Which finding would most directly indicate weak debt service capacity, as opposed to weak collateral or weak character?
Falling interest coverage from 4.0x to 1.2x shows operating earnings barely cover interest, which directly signals weakening capacity to service debt. The other findings concern collateral, management character or documentation protection rather than the borrower's cash flow ability to repay.
- AInterest coverage (EBIT/interest) has fallen from 4.0x to 1.2x over three yearsCorrect
- BThe pledged plant is valued at only 60% of the loan amount
- CThe CEO has a history of late filings with regulators
- DThe loan documentation lacks a negative pledge clause
Explanation
Capacity relates to the ability of cash flows to service debt, and a collapse in interest coverage shows this directly. Collateral value relates to the second way out, the CEO's filings relate to character, and missing covenants relate to structure and conditions.
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