Credit Analysis — Practice Q&A
Q: Walk through how you'd calculate DSCR for a borrower, including a common mistake to avoid.
A: DSCR is cash flow available for debt service divided by total debt service (principal plus interest due in the period). The common mistake is using raw operating cash flow directly, without first subtracting necessary maintenance capital expenditure — capex required just to maintain existing operations, not growth capex, which is a separate discretionary decision. Skipping this adjustment overstates the borrower's genuine debt-service capacity, since capex needed to sustain the business has to be funded before anything is truly available for loan repayment.
Q: Why is a DSCR of 0.9 considered a genuinely different, more severe situation than a DSCR of 1.1, even though both are relatively close to 1.0?
A: Below 1.0 means the borrower's operating cash flow alone doesn't cover their debt obligations — they would need to draw on cash reserves, raise new financing, or sell assets just to make scheduled payments, meaning debt service isn't self-sustaining from operations at all. Above 1.0, even if only slightly, debt service is at least technically self-funding from operations, though most lenders still want a meaningful cushion (often 1.2-1.5x) above that bare threshold to protect against actual results coming in below projections.
Q: A borrower's income statement shows 15% revenue growth, but you notice accounts receivable grew 40% over the same period. What does this suggest, and how would you confirm your suspicion?
A: This is a real warning sign worth investigating — it suggests the revenue growth may not be genuine, cash-generating growth, but rather growth achieved through increasingly generous payment terms extended to customers, with revenue sitting in receivables rather than converting to actual cash. The way to confirm this is checking the cash flow statement specifically — if operating cash flow is flat or declining despite the reported revenue growth, that confirms the growth isn't yet translating into real cash, which is exactly the kind of pattern that's only visible by reading the three financial statements together as one connected story rather than reviewing each in isolation.
Q: Why does the "Conditions" C in the 5 Cs framework matter as a distinct analytical layer, separate from analyzing the specific borrower's own financials?
A: Because even a genuinely well-managed, financially strong individual borrower can face real credit risk from industry-wide factors outside their direct control — a structural demand decline in their specific sector, a regulatory change, or industry-wide input cost pressure. A borrower's own historical financials don't necessarily reflect a forward-looking industry risk that hasn't yet shown up in past results, which is exactly why assessing industry Conditions separately from the borrower's own Character/Capacity/Capital/Collateral is necessary to catch this category of risk that purely borrower-specific ratio analysis alone would miss.
Q: Why isn't collateral book value the same as what a lender could actually recover in a default scenario?
A: Book value assumes normal-course conditions — normal-course sale for inventory, normal collection for receivables. In a genuine default and forced-liquidation scenario, inventory typically realizes significantly less than book value due to distressed sale pricing and potential obsolescence, and receivables often carry correlated risk since the borrower's own customers may be affected by whatever caused the borrower's distress in the first place, reducing actual collectability. This is exactly why Loan-to-Value ratios are typically set more conservatively for less liquid collateral types like inventory and receivables than for more reliably valued assets like real estate.
Q: A borrower who has been consistently paying on time suddenly requests a covenant waiver, even though no actual payment default has occurred. How should a credit analyst interpret this?
A: This should be treated as a genuine early warning signal worth proactive investigation, not dismissed simply because no default has technically occurred yet — a proactive request for relief often signals that the borrower already sees financial trouble coming before it shows up as an actual missed payment. Waiting for an actual default before engaging means missing the entire window where proactive intervention (a conversation, tightened monitoring, or early restructuring discussion) could meaningfully improve the outcome for both lender and borrower, compared to reacting only once the 90-day NPA threshold is reached.
Q: How would you decide between simply extending a distressed borrower's loan terms versus pursuing recovery/enforcement action?
A: The decision should depend on the underlying CAUSE of the distress, not just the immediate symptom of a missed or late payment. If the stress reflects a temporary, identifiable, addressable cause — a specific project delay, a temporary industry downturn with a credible recovery path — extending or modifying terms is appropriate, since the underlying business remains fundamentally viable. If the underlying business is genuinely no longer viable, further extension typically only delays an inevitable loss while allowing it to potentially grow larger — recovery action, while harder, addresses the situation while the loss is still more manageable. Defaulting to simple extension regardless of the actual underlying cause risks "evergreening" a fundamentally non-viable loan.