Credit Risk Analysis and Interpretation 5e Full Test Bank

Module 4

Credit Risk Analysis

and Interpretation

Module 4: Credit Risk Analysis and Interpretation

Multiple Choice

Topic: Demand for Credit

LO: 1

1. Many companies have cyclical operating cash needs due to:

1. Mergers and acquisitions
2. The seasonality of sales
3. Delays in customer payments
4. Refinancing of debt

Topic: Demand for Credit

LO: 1

2. An example of a situation in which company needs credit for investing activities is:

1. Mergers and acquisitions
2. Seasonal sales patterns
3. Start-up operating losses
4. Refinancing of debt

Topic: Supply of Credit

LO: 1

3. A letter of credit:

1. Ensures a company that funds will be available when needed
2. Is analogous to a credit card that companies can draw on as needed
3. Is a representation that a company has a high credit rating
4. Provides a guarantee of payment from the buyer, reducing the credit risk to the seller

Topic: Supply of Credit

LO: 1

4. Commercial paper is issued with maturities that do not exceed 270 days because:

1. Companies do not want to pay high interest rates.
2. It exempts the borrowing from SEC regulation.
3. Usually the collateral consists of short-term assets
4. Companies use it to fund working capital needs.

Topic: Credit Risk Analysis Process

LO: 2

5. Expected credit loss is calculated as:

1. Chance of default X Total Debt
2. Chance of default X Z-Score
3. Chance of default X Loss given default
4. Chance of default X Market value of Equity

Topic: Credit Risk Analysis Process

LO: 2

6. The overarching purpose of credit risk analysis is to:

1. Quantify potential credit losses
2. Determine a company’s optimal capital structure
3. Identify credit opportunities
4. Provide information to banks about credit losses

Topic: Credit Risk Analysis Process

LO: 2

7. Which of the following is not one of Porter’s five forces that determine a company’s competitive intensity?

1. Supplier power
2. Threat of substitution
3. Ability to obtain financing
4. Threat of entry

Topic: Analyzing Credit Risk

LO: 3

8. Fey Company currently has a current ratio of 0.7. The company decides to borrow $5,000,000 from Huntington Bank for a period of nine months. After the borrowing Fey Company’s current ratio will be:

1. Greater than 0.7
2. 0.7
3. Less than 0.7
4. Unable to determine without more information

Topic: Analyzing Credit Risk

LO: 3

9. Wilmington Corporation’s current ratio in 2017 was:

1. 0.92
2. 1.44
3. 0.69
4. 2.02

Topic: Analyzing Credit Risk

LO: 3

10. Wilmington Corporation’s quick ratio in 2017 was:

1. 0.92
2. 0.81
3. 1.09
4. 1.44

Topic: Analyzing Credit Risk

LO: 3

11. Wilmington Corporation’s quick ratio changed by what percentage from 2016 to 2017?

1. + 15.0%
2. + 87.0%
3. + 9.1%
4. – 8.5%

Topic: Analyzing Credit Risk

LO: 3

12. Wilmington Corporation’s liabilities to equity ratio in 2017 was:

1. 0.99
2. 1.09
3. 1.05
4. 1.79

Topic: Analyzing Credit Risk

LO: 3

13. Wilmington Corporation’s total debt to equity ratio in 2017 was:

1. 1.31
2. 0.38
3. 0.56
4. 0.29

Topic: Analyzing Credit Risk

LO: 3

14. Wilmington Corporation’s times interest earned ratio in 2017 was:

1. 18.15
2. 20.57
3. 10.89
4. 19.16

Topic: Analyzing Credit Risk

LO: 3

15. Wilmington Corporation’s cash flow from operations to total debt ratio in 2017 was:

1. 0.80
2. 1.51
3. 1.92
4. 0.71

Topic: Analyzing Credit Risk

LO: 3

16. Wilmington Corporation’s free operating cash flow to total debt ratio in 2017 was:

1. 1.57
2. 0.80
3. 0.74
4. 1.92

Topic: Analyzing Credit Risk

LO: 3

17. Wilmington Corporation’s return on equity in 2017 was:

1. 35.1%
2. 20.6%
3. 17.1%
4. 47.9%

Topic: Analyzing Credit Risk

LO: 3

18. Wilmington Corporation’s return on assets in 2017 was:

1. 35.1%
2. 20.6%
3. 17.1%
4. 47.9%

Topic: Analyzing Credit Risk

LO: 3

19. Wilmington Corporation’s financial leverage in 2017 was:

1. 2.33
2. 0.94
3. 1.75
4. 0.43

Topic: Analyzing Credit Risk

LO: 3

20. What was Wilmington Corporation’s return on net operating assets (RNOA) in 2017? Assume a statutory tax rate of 37%.

1. 20.6%
2. 44.2%
3. 67.5%
4. 32.9%

Topic: Analyzing Credit Risk

LO: 3

21. What was Wilmington Corporation’s net operating profit margin (NOPM) in 2017? Assume a statutory tax rate of 37%.

1. 32.8%
2. 13.0%
3. 20.5%
4. 13.9%

Topic: Analyzing Credit Risk

LO: 3

22. Wilmington Corporation’s net operating assets (NOAT) in 2017 was:

1. 0.19
2. 3.58
3. 0.72
4. 5.18

Topic: Credit Limit

LO: 1, 2

23. A credit limit is:

1. A company’s total debt
2. The maximum that a company can borrow
3. The maximum that a creditor will allow a customer to owe at any point in time
4. The property that a company pledges to guarantee repayment

Topic: Covenants

LO: 2

24. Covenants represent:

1. The property that a company pledges to guarantee repayment
2. The maximum that a creditor will allow a customer to owe at any point in time
3. Promises the company makes to the creditor
4. Terms and conditions set forth in a lending agreement to reduce the probability of nonpayment

Topic: Bankruptcy Prediction Models

LO: 5

25. The variable Market Value of Equity divided by Total Liabilities in the Altman Z-Score measures which of the following concepts?

1. Current level of profitability
2. Current level of net operating assets
3. Current level of leverage
4. Current level of efficiency

Topic: Bankruptcy Prediction Models

LO: 5

26. Which of the following concepts is not captured by one of the variables in Altman’s Z-Score?

1. Current level of profitability
2. Current level of net operating assets
3. Current level of liquidity
4. Current level of efficiency

Topic: Bankruptcy Prediction Models

LO: 5

27. When considering the results of an Altman Z-Score analysis a score of 3.85 would suggest?

1. The company is in financial distress and there is a high probability of bankruptcy in the short term future.
2. The company is exposed to some risk of bankruptcy.
3. The company is healthy and there is a low bankruptcy potential in the short-term.
4. The company is healthy and there is a low bankruptcy potential in both the short and long-term.

Topic: Bankruptcy Prediction Models

LO: 5

28. The variable EBIT divided by Total Assets in the Altman Z-Score measures which of the following concepts?

1. Current level of profitability
2. Current level of leverage
3. Current level of liquidity
4. Current level of efficiency

Topic: Bankruptcy Prediction Models

LO: 5

29. When using Altman’s Z-Score a Type I error occurs when:

1. The company’s Z-score indicates the company is healthy, and the company stays healthy.
2. The company’s Z-score indicates the company is healthy, and the company goes bankrupt.
3. The company’s Z-score indicates the company will go bankrupt, and the company stays healthy.
4. The company’s Z-score indicates the company will go bankrupt, and the company stays bankrupt.

Topic: Bankruptcy Prediction Models

LO: 5

30. When using Altman’s Z-Score a Type II error occurs when:

1. The company’s Z-score indicates the company is healthy, and the company stays healthy.
2. The company’s Z-score indicates the company is healthy, and the company goes bankrupt.
3. The company’s Z-score indicates the company will go bankrupt, and the company stays healthy.
4. The company’s Z-score indicates the company will go bankrupt, and the company stays bankrupt.

Topic: Demand and Supply for Credit

LO: 1

1. Companies normally have a demand for credit due to the operating, investing and financing activities that they engage. For each activity provide a specific reason why a company would need credit.

Topic: Demand and Supply for Credit

LO: 1

2. Companies have many types of credit to access. Distinguish the differences between commercial paper and term loans.

Topic: Credit Risk Analysis Process

LO: 2

3. In the credit risk analysis process many parties assess the chance of default and loss given default. How do credit rating agencies methods differ from other parties?

Topic: Analyzing Credit Risk

LO: 2

4. When analyzing the chance of default many analysts use Porter’s Five Forces to assess broader business forces affecting a company in order to assess the company’s chance of default. What are five forces identified by Porter?

Topic: Credit Rating Process

LO: 4

5. Credit rating agencies provide ratings about a company’s ability to repay its obligations. While this is important information for creditors why should a company that is being rated care about its credit rating?

Topic: Analyzing Credit Risk

LO: 2

6. One way creditors attempt to minimize potential losses is by inserting covenants into the loan agreement. There are covenants that require borrowers take certain actions, covenants that restrict the borrower from taking certain actions and covenants that require the borrower to maintain specific financial ratios. For each of these types of covenants provide a specific example.

Topic: Bankruptcy Prediction Analysis

LO: 5

7. Below is selected information for Radek Corp. and Kitts, Inc. for fiscal 2017. Compute each company’s Z-score and provide an analysis of whether either company is expected to go bankrupt in the near future. (Round each computation to three decimal places.)

Topic: Bankruptcy Risk and Z-Score Analysis

LO: 5

8. Below is selected information for Innovative Components for fiscal 2017 and 2016. Compute the company’s Z-score for both years. Is the company’s bankruptcy risk increasing or decreasing over this period? (Round each computation to three decimal places.)

Topic: Bankruptcy Risk and Z-Score Analysis

LO: 5

9. Below is selected information for Butler Industries for fiscal 2017 and 2016. Compute the company’s Z-score for both years. Is the company’s bankruptcy risk increasing or decreasing over this period? (Round each computation to three decimal places.)

Topic: Bankruptcy Prediction Analysis

LO: 5

10. One method of assessing the likelihood that a company will go bankrupt is by computing its Z-score. Each variable in the Z-score relates to a measure of financial strength.

What are the five variables that comprise the Z-score and what measure of financial strength does each measure?

Topic: Bankruptcy Prediction Analysis

LO: 5

11. There are two types of errors that can arise when using the Z-score to assess the likelihood of bankruptcy. What are the two errors and what cost does each error create?

Topic: Compute and Interpret Liquidity, Solvency and Coverage Ratios

LO: 3

12. Below is selected balance sheet and income statement information from Fuller Enterprises.

1. Compute the current ratio for each year and discuss any trend in liquidity. (Round to two decimal places.)
2. Compute times interest earned, liabilities-to-equity, and cash from operations to total debt ratios for each year and discuss any trends for each. (Round to two decimal places.)

Topic: Compute and Interpret Liquidity, Solvency and Coverage Ratios

LO: 3

13. Below is selected balance sheet and income statement information from Pinto & Company.

1. Compute the current ratio for each year and discuss any trend in liquidity. (Round to two decimal places.)
2. Compute times interest earned, liabilities-to-equity, and cash from operations to total debt ratios for each year and discuss any trends for each. (Round two decimal places.)

Topic: Compute and Interpret Liquidity, Solvency and Coverage Ratios

LO: 3

14. Below is selected balance sheet and income statement information from Kerns Corporation.

1. Compute the following liquidity, solvency and coverage ratios for both years.

(Round each computation to two decimal places.)

• Current ratio
• Quick ratio
• Liabilities-to-equity
• Total debt-to-equity
• Times interest earned
• Cash from operations to total debt
• Free operating cash flow to total debt

1. What is your overall assessment of the company’s credit risk? Explain. What differences do you observe between the two years?

Topic: Compute and Interpret Liquidity, Solvency and Coverage Ratios

LO: 3

15. Below is selected balance sheet and income statement information from Hudson & Company.

1. Compute the following liquidity, solvency and coverage ratios for both years.

(Round each computation to two decimal places.)

• Current ratio
• Quick ratio
• Liabilities-to-equity
• Total debt-to-equity
• Times interest earned
• Cash from operations to total debt
• Free operating cash flow to total debt

1. What is your overall assessment of the company’s credit risk? Explain. What differences do you observe between the two years?

Topic: Bankruptcy Prediction Models

LO: 5

16. Wilmington Corporation Industries manufactures extreme weather survival equipment. Selected financial data for Wilmington Corporation is presented below.

Continued next page

Selected financial data for Wilmington Corporation continued:

Assuming that Wilmington Corporation’s market value of equity at the end of 2017 is $27 million, calculate Wilmington Corporation’s Z-score?

Topic: Demand and Supply for Credit

LO: 1

1. Companies have many types of credit to access. For each of the following terms provide a concise definition:
2. Line of credit
3. Letter of credit
4. Revolving credit line

Topic: Credit Risk Analysis Process

LO: 2, 3

1. When assessing a company’s chance of default analysts normally try to predict the company’s future performance and cash flow in order to determine the likelihood the company will be able to repay the loan.

What are the four steps that an analyst would take to determine a company’s chance of default?

Topic: Credit Risk Analysis Process

LO: 3

3. Refer to the fiscal 2017 income statement and balance sheet of Mullen, Inc. provided below:

Continued next page

Required: Compute the following liquidity, solvency and coverage ratios for 2017 and 2016 for Mullen, Inc.:

• Current ratio
• Quick ratio
• Liabilities to equity ratio
• Total debt-to-equity ratio
• Times interest earned ratio (2017 only)

Topic: Analyzing Credit Risk

LO: 3

4. Selected balance sheet and income statement information for Brighton Homes, a residential home builder, follows (all amounts in millions):

Required:

a. Compute the current ratio for each year and discuss any trend in liquidity. What additional information about the numbers might be useful in helping you assess liquidity?

b. Brighton Homes largest single current asset is its inventory of developed and undeveloped land. Does this change your conclusion about liquidity?

c. Compute times interest earned, liabilities to equity and cash from operations to total debt for each year and discuss any trends for each ratio.

Topic: Predicting Bankruptcy Risk

LO: 5

5. Following is information concerning Howell Company (all amounts in millions):

Required: Compute and compare the Altman Z-score for the three years provided, what trend appears? Is Howell Company more or less likely to go bankrupt given the Z-score in 2015 or 2017?

Topic: Compute and Interpret Z-Scores

LO: 5

6. Selected balance sheet and income statement information for Camden Corporation follows. As of December 31, 2017 and 2016, there were approximately 434,264,432 and 440,445,630 shares outstanding. The company’s stock closed at $63.63 on December 31, 2017 and $55.55 on December 31, 2016. Dividends paid (in millions) were $405 and $462 in 2016 and 2017, respectively.

Table continued next page

Table continued

Required:

a. Compute and compare the Altman Z-scores for both years. What explains the apparent trend?

b. Is the company more likely to go bankrupt given the Z-score in 2017 compared to 2016? Explain.

Topic: Compute and Interpret Z-Scores

LO: 5

7. Selected balance sheet and income statement information for Aiello, Inc. follows. As of December 31, 2017 and 2016, there were approximately 525.5 million and 517.5 million shares outstanding. The company’s stock closed at $73.79 on December 31, 2017 and $62.84 on December 31, 2016. Dividends paid (in millions) were $19,668 and $23,251 in 2016 and 2017, respectively.

Table continued next page

Table continued

Required:

a. Compute and compare the Altman Z-scores for both years. What explains the apparent trend?

b. Is the company more likely to go bankrupt given the Z-score in 2017 compared to 2016? Explain.