CHAPTER 5

RISK ANALYSIS
Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases

5.5. Effect of Transactions on Debt Ratios.

a. The effect of the four transactions on each debt ratio is as follows:

(1) Issue Long-Term Debt for Cash:

Liabilities to Assets Ratio: increase
Liabilities to Shareholders’ Equity Ratio: increase
Long-Term Debt to Long-Term Capital Ratio: increase
Long-Term Debt to Shareholders’ Equity Ratio: increase

(2) Issue Short-Term Debt and Use the Cash Proceeds to Redeem Long-Term Debt:
Liabilities to Assets Ratio: no net effect
Liabilities to Shareholders’ Equity Ratio: no net effect
Long-Term Debt to Long-Term Capital Ratio: decrease
Long-Term Debt to Shareholders’ Equity Ratio: decrease

(3) Redeem Short-Term Debt with Cash:

Liabilities to Assets Ratio: decrease
Liabilities to Shareholders’ Equity Ratio: decrease
Long-Term Debt to Long-Term Capital Ratio: no net effect
Long-Term Debt to Shareholders’ Equity Ratio: no net effect

(4) Issue Long-Term Debt and Use the Cash Proceeds to Repurchase Common Stock:
Liabilities to Assets Ratio: increase
Liabilities to Shareholders’ Equity Ratio: increase
Long-Term Debt to Long-Term Capital Ratio: increase
Long-Term Debt to Shareholders’ Equity Ratio: increase

b. The four debt ratios move in the same direction except for transactions that in whole or
in part involve cash and short-term debt [Transactions (2) and (3)]. When the
latter occurs, the liabilities to assets ratio and the liabilities to shareholders’
equity ratios move in the same direction and the long-term debt to long-term capital
and long-term debt to shareholders’ equity move in the same direction. Thus,
these debt ratios are highly correlated. To identify changes in short- versus
long-term debt, the analyst should use one of the two ratios with total liabilities in the
numerator and one of the two ratios with long-term debt in the numerator.

https://www.coursehero.com/file/7712546/ACT-454-Chap-5/
5.12. Calculating and Interpreting Risk Ratios.
a. Revenues to Cash Ratio: $2,998/.5($521 + $725) = 4.8
Days Revenues in Cash: 365/4.8 = 76 days
Current Ratio: $1,718/$1,149 = 1.5
Quick Ratio: ($725 + $579)/$1,149 = 1.1
Operating Cash Flow to Current Liabilities Ratio:
$358/.5($930 + $1,149) = 0.344
Days Accounts Receivable:
$2,998/.5($607 + $579) = 5.1; 365/5.1 = 72 days
Days Inventory:
$1,252/.5($169 + $195) = 6.9; 365/6.9 = 53 days
Days Accounts Payable:
($1,252 + $195 – $169)/.5($159 + $168) = 7.8; 365/7.8 = 47 days
Net Days Working Capital: 72 + 53 – 47 = 78 days
Liabilities to Assets Ratio: $1,601/$3,241 = 0.494
Liabilities to Shareholders’ Equity Ratio: $1,601/$1,640 = 0.976
Long-Term Debt Ratio to Long-Term Capital Ratio:
$303/($303 + $1,640) = 0.156
Long-Term Debt to Shareholders’ Equity Ratio: $303/$1,640 = 0.185
Operating Cash Flow to Total Liabilities Ratio:
$358/$.5($1,758 + $1,601) = 0.213
Interest Coverage Ratio: ($196 + $32 + $64)/$32 = 9.1

b. The changes in the short-term liquidity risk ratios present mixed signals. Hasbro has
built up its balance in cash so that it has more days of revenue held in cash. This trend
provides Hasbro with liquidity and reduces its short-term liquidity risk. The
current and quick ratios were steady during the three years and at healthy levels. Again,
these results suggest low short-term liquidity risk. The operating cash flow to
current liabilities ratio declined, and by Year 4, it was less than the 40 percent
found for healthy companies. The decrease in this ratio is the result of declining cash
flow from operations and increasing current liabilities. Net income increased each year
so that the declining cash flow from operations is the result of changes in non-cash
revenues and expenses and in operating working capital accounts. Exhibit 4.30
indicates that the addback for depreciation and amortization decreased during
the three years. Depreciation and amortization do not affect cash flows; the
smaller addback simply offsets the smaller expense. Thus, changes in
depreciation and amortization do not explain the declining cash flow from
operations. It appears that the explanation lies primarily in a decrease in
prepayments in Year 2 and a decrease in accounts payable and other current liabilities
in Year 4. The analyst would be concerned with the decrease in current
liabilities in Year 4 only if it signaled pressure from suppliers of various goods
and services to pay their amounts due. Even then, Hasbro has more than sufficient cash
and accounts receivable to cover all current liabilities. The net days of working capital
declined sharply between Year 2 and Year 3 as a result of reducing the days accounts
receivable and inventory being held, a positive sign in terms of reducing short-term
liquidity risk. This occurred in a year when sales increased. The net days of working
capital increased again in Year 4, a year in which sales decreased. It would
 not appear that Hasbro is unduly risky in terms of short-term liquidity risk at the end of
Year 4. Its current and quick ratios are at healthy levels and its days inventory
and accounts payable have been steady for the past two years. The only troublesome
aspect is the declining operating cash flow to current liabilities ratio. This ratio is
not at a level of extreme concern in Year 4, but a continuation of this trend
could become troublesome.

c. Hasbro’s long-term solvency risk has decreased significantly during the three-year
period. Debt levels have declined as Hasbro has redeemed debt. (See Hasbro’s
statement of cash flow in Exhibit 4.30.) Its interest coverage ratio has increased from a
worrisome level in Year 2 to a very healthy level in Year 4. The latter
occurred because of a reduction in borrowing and an increase in net income. Its
operating cash flow to total liabilities ratio has been steady and above the 20 percent
threshold for a healthy company. The reduced debt offset the declining cash flow from
operations to provide a relatively stable cash flow ratio. The level of long-term
solvency risk at the end of Year 4 appears low.

5.15. Computing and Interpreting Risk and Bankruptcy Prediction Ratios for a Firm That
Declared Bankruptcy.
a. (1) Current Ratio:
2000: $3,205/$5,245 = .61
2001: $3,567/$6,403 = .56
2002: $3,902/$6,455 = .60
2003: $4,550/$6,157 = .74
2004: $3,606/$5,941 = .61

(2) Operating Cash Flow to Current Liabilities Ratio:

2001: $236/.5($5,245 + $6,403) = 0.041
2002: $225/.5($6,403 + $6,455) = 0.035
2003: $142/.5($6,455 + $6,157) = 0.023
2004: $(1,123)/.5($6,157 + $5,941) = (0.186)

(3) Liabilities to Assets Ratio:

2000: $16,354/$21,931 = 0.746
2001: $19,581/$23,605 = 0.830
2002: $23,563/$24,720 = 0.953
2003: $26,323/$25,939 = 1.015
2004: $27,320/$21,801 = 1.253

(4) Long-Term Debt to Long-Term Capital Ratio:

2000: $5,797/($5,797 + $5,577) = 0.510
2001: $7,781/($7,781 + $4,024) = 0.659
2002: $9,576/($9,576 + $1,157) = 0.892
2003: $11,040/($11,040 – $384) = 1.036
2004: $12,507/($12,507 – $5,519) = 1.790
 (5) Operating Cash Flow to Total Liabilities Ratio:
2001: $236/.5($16,354 + $19,581) = 0.013
2002: $225/.5($19,581 + $23,563) = 0.010
2003: $142/.5($23,563 + $26,323) = 0.006
2004: $(1,123)/.5($26,323 + $27,320) = (0.042)

(6) Interest Coverage Ratio:

2000: $1,829/$380 = 4.8
2001 to 2004: The interest coverage ratio is negative and, therefore, is
not covered.
b. Altman’s Z-Score

2000
Working Capital/Assets: 1.2[($3,205 – $5,245)/$21,931].................... (.112)
Retained Earnings/Assets: 1.4($4,176/$21,931)................................... .267
EBIT/Assets: 3.3($1,829/$21,931) ....................................................... .275
Mkt. Value Equity/Liabilities: .6[(123 x $50.185)/$16,354]................ .226
Sales/Assets: 1.0($15,657/$21,931)...................................................... .714
Z-Score................................................................................................ 1.370

Probability of Bankruptcy...................................................................... 35.5%

2001
Working Capital/Assets: 1.2[($3,567 – $6,403)/$23,605].................... (.144)
Retained Earnings/Assets: 1.4($2,930/$23,605)................................... .174
EBIT/Assets: 3.3($–1,365/$23,605) ..................................................... (.191)
Mkt. Value Equity/Liabilities: .6[(123 x $29.26)/$19,581].................. .110
Sales/Assets: 1.0($13,879/$23,605)...................................................... .588
Z-Score................................................................................................ .537

Probability of Bankruptcy...................................................................... 67.8%

2002
Working Capital/Assets: 1.2[($3,902 – $6,455)/$24,720].................... (.124)
Retained Earnings/Assets: 1.4($1,639/$24,720)................................... .093
EBIT/Assets: 3.3($–1,337/$24,720) ..................................................... (.178)
Mkt. Value Equity/Liabilities: .6[(123.4 x $12.10)/$23,563]............... .038
Sales/Assets: 1.0($13,866/$24,720)...................................................... .561
Z-Score................................................................................................ .390

Probability of Bankruptcy...................................................................... 72.9%

 2003
Working Capital/Assets: 1.2[($4,550 – $6,157)/$25,939].................... (.074)
Retained Earnings/Assets: 1.4($844/$25,939)...................................... .046
EBIT/Assets: 3.3($–432/$25,939) ........................................................ (.055)
Mkt. Value Equity/Liabilities: .6[(123.5 x $11.81)/$26,323]............... .033
Sales/Assets: 1.0($14,087/$25,939)...................................................... .543
Z-Score................................................................................................ .493

Probability of Bankruptcy...................................................................... 69.4%

2004
Working Capital/Assets: 1.2[($3,606 – $5,941)/$21,801].................... (.129)
Retained Earnings/Assets: 1.4($–4,373/$21,801)................................. (.281)
EBIT/Assets: 3.3($–3,168/$21,801) ..................................................... (.480)
Mkt. Value Equity/Liabilities: .6[(139.8 x $7.48)/$27,320]................. .023
Sales/Assets: 1.0($15,002/$21,801)...................................................... .688
Z-Score................................................................................................ (.179)

Probability of Bankruptcy...................................................................... 88.1%

c. The risk ratios are at very week levels throughout the five years, and consistent with
these ratio results, the Altman Z-score model shows a high probability of bankruptcy in
all years. One interesting insight is that even in 2000, when Delta Air Lines
was profitable and its deteriorating financial health had not yet ramped up, it showed
weak risk ratios and a fairly high probability of bankruptcy. The working capital and
asset turnover ratios in the Altman model did not show much deterioration over the five-
year period. However, its declining profitability contributed to increasing
operating cash flow problems, lowered shareholders’ equity, and increased
liabilities. The deterioration in 2004 was particularly pronounced. In one
sense, the Altman model shows why the probability of bankruptcy is so high for Delta
Air Lines. On the other hand, one might say that Delta Air Lines remained out of
bankruptcy for longer than the Altman model would predict. Airlines are able to
weather financial storms somewhat longer than manufacturing firms because lenders
can rely on the collateral provided by airplanes and not force liquidation. In addition,
continuing to offer flights is critical to keeping customers, even if the flights are
operated at a net loss. However, despite attempts at cost cutting through 2004, the
airline filed for bankruptcy on September 14, 2005.
5.18 Applying and Interpreting Bankruptcy Prediction Models.
a. Altman’s Z-Score for Harvard Industries

Year 5
Working Capital/Assets: 1.2[($195,417 – $176,000)/$662,262].......... .035
Retained Earnings/Assets: 1.4(–$115,596/$662,262)........................... (.244)
EBIT/Assets: 3.3($40,258/$662,262) ................................................... .201
Mkt. Value Equity/Liabilities: .6[(6,995 x $100.50)/$624,817]........... .675
Sales/Assets: 1.0($631,832/$662,262).................................................. .954
Z-Score................................................................................................ 1.621

Probability of Bankruptcy...................................................................... 26.7%

Year 6
Working Capital/Assets: 1.2[($156,226 – $163,384)/$617,705].......... (.014)
Retained Earnings/Assets: 1.4(–$184,308/$617,705)........................... (.418)
EBIT/Assets: 3.3(–$11,012/$617,705) ................................................. (.059)
Mkt. Value Equity/Liabilities: .6[(7,014 x $85)/$648,934].................. .551
Sales/Assets: 1.0($824,835/$617,705).................................................. 1.335
Z-Score................................................................................................ 1.395

Probability of Bankruptcy...................................................................... 34.6%

Altman’s Z-Score for Marvel Entertainment

Year 5
Working Capital/Assets: 1.2[($490,600 – $318,100)/$1,226,310]....... .169
Retained Earnings/Assets: 1.4($114,100/$1,226,310).......................... .130
EBIT/Assets: 3.3($25,100/$1,226,310) ................................................ .068
Mkt. Value Equity/Liabilities: .6[(101,703 x $10.625)/$948,100]....... .684
Sales/Assets: 1.0($828,900/$1,226,310)............................................... .676
Z-Score................................................................................................ 1.727

Probability of Bankruptcy...................................................................... 23.4%

Year 6
Working Capital/Assets: 1.2[($399,500 – $345,800)/$844,000].......... .076
Retained Earnings/Assets: 1.4(–$350,300/$844,000)........................... (.581)
EBIT/Assets: 3.3(–$370,200/$844,000) ............................................... (1.447)
Mkt. Value Equity/Liabilities: .6[(101,810 x $1.625)/$999,700]......... .099
Sales/Assets: 1.0($745,400/$844,000).................................................. .883
Z-Score................................................................................................ (.970)

Probability of Bankruptcy...................................................................... 97.6%

b. The Z-scores for Harvard Industries were in the range indicating a high probability of
bankruptcy in both fiscal Year 5 and fiscal Year 6. The firm has negative
retained earnings, indicating a history of net losses. The negative retained
earnings is a principal factor accounting for the firm’s Z-score falling in the high
probability of bankruptcy range. The Z-score decreased significantly between
Year 5 and Year 6. The firm operated at a net loss in fiscal Year 6, after
generating net earnings in the preceding two years. The net loss in fiscal Year 6
reduced working capital and hurt the short-term liquidity ratios. Sales declined between
fiscal Year 5 and fiscal Year 6 and hurt the asset turnover.

c. The Z-scores of Marvel Entertainment fall in the range indicating a high probability of
bankruptcy in both years. Weak profitability, high levels of liabilities to assets,
and slow asset turnovers explain the low Z-scores. The decline in the Z-scores
between fiscal Year 5 and fiscal Year 6 results from substantially reduced profitability.
Sales declined between the two years, consistent with the effect of reduced youth
readership and interest in trading cards.

d. Application of the bankruptcy prediction model suggests that Marvel Entertainment is

more likely to file for bankruptcy during fiscal Year 7. The Z-score of Marvel
Entertainment is lower and its probability of bankruptcy is higher for fiscal Year 6 than
the corresponding ratio for Harvard Industries. Three positive signals for
Harvard Industries include (1) a sales increase between fiscal Year 5 and fiscal
Year 6, in contrast to the sales decrease for Marvel Entertainment; (2) a higher assets
turnover for Harvard Industries; and (3) a much higher market price per common share
for Harvard Industries, suggesting that the market perceives the firm’s problems as
correctable or the market does not perceive the bankruptcy risk of the firm. In
addition, the automobile industry is a more viable industry long-term compared to
comic books and trading cards.
Interestingly, both of these firms filed for bankruptcy during fiscal Year 7.