5. Cash !ow analysis is critical to understanding a borrower’s ability to repay a loan. Earnings
figures can be especially misleading given how firms historically managed earnings and
manipulated the data. Still, cash !ow figures can be manipulated as well. Students need to
review financial statements carefully, including footnotes to get a sense of management’s
approach to financial reporting. The requirement that CEOs sign-o8 on the accuracy of
financial statements, introduced in August 2002, should help improve the quality of data.
6. The example for Wade’s O7ce Furniture demonstrates the credit analysis process and issues
that commonly arise.
7. Many financial institutions have changed their business models to originate-to-distribute.
Under this model, firms make loans and thereby collect feels, then either sell parts of the
loan though participations or package the loans into pools and sell them.
8. Credit enhancements reduce the risk of investing in loan sales or loan participations.
9. Credit default swaps (CDS) contracts are privately negotiated instruments between a buyer
and a seller and are traded in over-the-counter markets. The buyer pays a premium, which
represents the risk of default of the underlying security, and thus the CDS is similar to an
insurance contract. The buyer often owns the underlying debt and uses the CDS as a hedge.
The seller of the CDS plays a role similar to that of the insurance company. Sellers generally
do not own the debt and provide longer-term protection. If an adverse event occurs, such as
a default of the underlying instrument, the seller pays the buyer the change in value of the
underlying asset.
Teaching Suggestions
Chapter 14 introduces the quantifiable aspects of commercial credit analysis. It serves as a
foundation for making credit decisions. Emphasize that credit analysis is risk analysis. There are
no definite answers, only an assessment of the risks associated with lending funds. Discuss the
basic questions that must be answered appropriately before a lender should advance funds to a
borrower. The answers determine the risk of the loan request, which affect the terms and
pricing of the eventual loan agreement if the loan is made.
The discussion in Chapter 3 regarding bank financial statements and performance data and the
discussion in Chapter 14 should emphasize the quality of financial information and reporting
errors and fraud that was found with many large corporations. You should spend time discussing
issues related to the accuracy of accounting information, the con!icts accounting firms have
when they sell consulting services to the same firms that they audit, and the propensity of CEOs
and other managers to in!ate profits by strategically understating expenses or overstating
revenues. Mention the term ‘earnings management’ and discuss specifics regarding whether it
exists and whether it is successful. The role of the credit analyst is to peer through the data to
get a reasonable assessment of a firm’s true risk exposure. Still, the quality of the analysis is tied
to the quality of the financial data, so students should learn to look for tricks that firms play in
reporting.