Credit Risk Management Practice Exam

What do financial institutions typically analyze to assess credit risk in non-financial firms?

1. Borrower's credit history

2. Liquidity and cash flow

3. The length of the loan

4. Interest rate trends

The correct answer is: Liquidity and cash flow

Financial institutions analyze liquidity and cash flow to assess credit risk in non-financial firms because these factors provide insight into a firm's ability to meet its short-term obligations and sustain operations. Liquidity measures how easily an asset can be converted into cash, which is essential for a company's day-to-day business activities. Analyzing cash flow helps institutions understand the inflows and outflows of cash within the firm, indicating whether it can generate sufficient revenue to cover expenses and service debt. When firms have strong liquidity and positive cash flow, they are seen as less risky because they are more likely to weather financial difficulties and fulfill their contractual obligations. In contrast, inadequate liquidity or negative cash flow might signal potential financial distress, raising concerns about the firm’s ability to repay loans. Other factors, such as a borrower's credit history, may play a role in the overall credit assessment, but liquidity and cash flow provide direct information about a company's current financial health and operational viability, making them particularly critical for evaluating credit risk. The length of the loan or interest rate trends are also relevant to overall credit analysis but are not as pivotal in directly assessing a firm's immediate financial stability and risk profile.