CFA Level II ExamFixed IncomeEasy
A credit analyst is evaluating the creditworthiness of a company. The company has a high debt-to-equity ratio, declining revenue growth, and a history of volatile earnings. The analyst notes that the company's industry is highly cyclical and competitive. Which of the following factors would most likely contribute to a higher probability of default for this company?
- AA tightening of credit markets, making refinancing more difficult.
- BA significant increase in the company's cash reserves.
- CA recent upgrade in the company's credit rating by a major agency.
- DA successful diversification into a less cyclical industry segment.
Show answer & explanationAnswer & explanation
Correct answer: A. A tightening of credit markets, making refinancing more difficult.
A tightening of credit markets increases the cost of borrowing and makes it more challenging for companies, especially those with already weak financial profiles, to refinance existing debt or secure new funding. This directly elevates the risk of default.
Why the other options are wrong
- B. Increased cash reserves would improve liquidity and *reduce* the probability of default.
- C. A credit rating upgrade would indicate a *lower* probability of default, contradicting the question.
- D. Diversification into a less cyclical industry would likely *reduce* earnings volatility and improve creditworthiness, lowering default risk.
Credit Risk Factors
Credit risk factors are variables that influence a borrower's ability or willingness to meet its financial obligations, thereby affecting the probability of default.
- Financial leverage (debt-to-equity) is a key indicator.
- Profitability and cash flow generation are crucial for debt servicing.
- Industry cyclicality and competitive landscape impact revenue stability.
- Access to capital markets and refinance options are critical liquidity considerations.
Memory trick: Debt's tight grip makes default slip.