Deck 10: Credit Analysis

Question 1

Which of the following will not affect the calculation of leverage ratios?

A) existence of non-capitalized operating leases
B) existence of assets where market value is much higher than book value
C) existence of significant debt covenants
D) existence of pension liabilities where projected benefit liability is much greater than plan assets and accumulated benefit obligation

Answer 1

C

Question 2

Which of the following is not likely to be the cause of a company's a low accounts receivable turnover?

A) Poor collection efforts
B) Low price of product
C) Customers in financial distress
D) Delays in customer payments

Answer 2

B

Question 3

Sellograph Corporation reports sales of $10M for Year 2, with a gross profit margin of 40%. 20% of Sellograph's sales are on credit.
$$\begin{array} { | l | r | r | } \hline & \text { Year 1 } & \text { Year 2 } \\\hline \text { Accounts receivable } & \$ 150,000 & \$ 170,000 \\\hline \text { Inventory } & 900,000 & 1,000,000 \\\hline \text { Accounts payable } & 1,100,000 & 1,200,000 \\\hline\end{array}$$

-Accounts payable days outstanding at the end of Year 2 is closest to:

A) 57.0 days
B) 69.0 days
C) 72.0 days
D) 43.2 days

Answer 3

72.0 days

Question 4

Sellograph Corporation reports sales of $10M for Year 2, with a gross profit margin of 40%. 20% of Sellograph's sales are on credit.
$$\begin{array} { | l | r | r | } \hline & \text { Year 1 } & \text { Year 2 } \\\hline \text { Accounts receivable } & \$ 150,000 & \$ 170,000 \\\hline \text { Inventory } & 900,000 & 1,000,000 \\\hline \text { Accounts payable } & 1,100,000 & 1,200,000 \\\hline\end{array}$$

-Accounts receivable days outstanding at the end of Year 2 is closest to:

A) 30.6 days
B) 28.8 days
C) 27.0 days
D) 6.1 days

Question 5

Which of the following is not a measure of a company's a solvency?

A) Debt to equity ratio
B) Equity to assets ratio
C) Sales to assets ratio
D) Debt to assets ratio

Question 6

Imagine FASB passes a new rule that required the capitalization of R&D. The effect for a drug company would be to:

A) Increase its current ratio
B) Decrease debt/equity ratio
C) Decrease working capital
D) Improve asset turnover

Question 7

Which of the following does not represent future expected cash inflows?

A) accounts receivable
B) prepaid expenses
C) inventory
D) notes receivable

Question 8

An analyst should treat preferred stock on a firm's balance sheet as debt when calculating leverage ratios if the preferred stock is:

A) redeemable by shareholders
B) convertible into common stock
C) issued at a variable dividend rate
D) callable by the issuer

Question 9

Which of the following items would not typically be included in the components of the current ratio?

A) Inventory
B) Accounts payable
C) Capitalized software development costs
D) Deferred charges

Question 10

Using LIFO rather than FIFO in a time of rising prices:
I) lowers the current ratio
II) increases inventory turnover
III) increases profit margin
IV) increases debt/equity ratio

A) I, II and IV
B) I and II
C) II and III
D) I only

Question 11

Which of the following best describes the current ratio?

A) debt ratio
B) operating performance ratio
C) liquidity ratio
D) efficiency ratio

Question 12

Which of the following industries would you expect to have the highest inventory turnover?

A) restaurant
B) car dealer
C) jewelry store
D) department store

Question 13

Which of the following industries would you expect to have the longest operating cycle?

A) Fast Food Industry
B) Aerospace Industry
C) Discount retail store industry
D) Utility industry

Question 14

Selling accounts receivable increases which of the following?

A) current ratio
B) accounts receivable turnover
C) debt/equity
D) effective tax rate

Question 15

Which of the following is not likely to be used to measure a company's liquidity?

A) Working capital
B) Financial leverage
C) Current ratio
D) Acid-test (quick) ratio

Question 16

Which of the following is likely to be used to measure a company's solvency?

A) Net operating profit margin
B) Current ratio
C) Financial leverage
D) Cash to current liabilities ratio

Question 17

Days in inventory at the end of Year 2 is closest to:

A) 60.0 days
B) 69.0 days
C) 66.0 days
D) 54.0 days

Question 18

Which of the following would be least likely to affect the quality of receivables?

A) Credit policy
B) Right of return policy
C) Collection procedures
D) Sales commissions

Question 19

If a firm capitalizes a lease instead of treating the lease as an operating lease, the effect on the current ratio and the debt-to-equity ratio will be to: $$\begin{array} { | l | l | l | } \hline & \text { Current Ratio } & \text { Debt-to-Equity Ratio } \\\hline \text { A) } & \text { Increase } & \text { Increase } \\\hline \text { B) } & \text { No effect } & \text { Increase } \\\hline \text { C) } & \text { No effect } & \text { Decrease } \\\hline \text { D) } & \text { Decrease } & \text { Increase } \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D

Question 20

Which of the following statements concerning the current ratio are true?
I) It is always larger than the acid-test (quick) ratio
II) Companies can window-dress their current ratios
III) In isolation the current ratio has little meaning
IV) It is a good indicator of solvency of a company

A) I, II, III and IV
B) I, II and III
C) II, III and IV
D) I, II and IV

Question 21

You are calculating the earnings to fixed charges ratio for a company. Which of the following is incorrect?

A) Interest expense is considered a fixed charge
B) Long-term rental payments are often considered fixed charges
C) Senior managements' salaries are normally considered fixed charges
D) Preferred stock dividends are normally considered fixed charges

Question 22

Which of the following statements are correct with respect to the times interest earned ratio?
I) It is independent of operating income
II) It is independent of the interest rate paid on debt
III) It is independent of the tax rate
IV) It is independent of the amount of dividends paid

A) I, II and III
B) I and III
C) I and IV
D) III and IV

Question 23

If a company wishes to increase its current ratio, it could:

A) take out a short-term loan
B) pay suppliers more quickly
C) increase useful life of machinery
D) not determinable without more information

Question 24

If a company's current ratio increases from 1.2 to 1.4 from one year to the next, and its quick ratio decreases from 0.2 to 0.15 over the same time period, this indicates:

A) company's liquidity must have increased
B) accounts receivable have decreased
C) inventory management should be further examined
D) current liabilities have decreased

Question 25

Financial leverage ratio for Company A and B for 2005 are: $$\begin{array} { | c | c | c | } \hline & \text { Company A } & \text { Company B } \\\hline \text { A) } & 1.0 & 1.0 \\\hline \text { B) } & 2.0 & 1.0 \\\hline \text { C) } & 0.70 & 0.6 \\\hline \text { D) } & 0.50 & 1.0 \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D

Question 26

If a company's current ratio increases from 1.1 to 1.3 from one year to the next, it can be concluded that:

A) company's liquidity has increased
B) current assets have increased
C) current liabilities have decreased
D) none of the above

Question 27

A company wishes to increase its financial leverage. Which of the following actions, all other things being equal, will achieve this?
I) Repurchase stock
II) Issue more dividends
III) Sell accounts receivable at face value
IV) Split stock 2 for 1

A) I, II and III
B) I and II
C) I and IV
D) I, II and IV

Question 28

The earnings to fixed charges ratio:

A) indicates how efficiently assets are used
B) typically includes depreciation in the denominator
C) typically excludes extraordinary gains and losses from the numerator
D) indicates the proportion of debt used to finance the company

Question 29

Company B has operating leases with a present value of $2,000 when future minimum lease payments are discounted at 9% as of 12/31/04. Times interest earned ratio, after necessary adjustments, for Company B is:

A) 10.26
B) 9.26
C) 6.56
D) 5.55

Question 30

ABC company is planning a major expansion for which it needs $5 million in external funding. It has various options as how to finance this expansion. Which of the following is correct?

A) Future ROA will be higher if it uses all equity financing than if it uses some debt financing
B) Future net income will be higher if it uses common stock rather than preferred stock to finance expansion
C) Future ROA is independent of the form of financing
D) Future net income is independent of the form of financing

Question 31

Return on assets for Company A and B for 2005 are: $$\begin{array} { | c | c | c | } \hline & \text { Company A } & \text { Company B } \\\hline \text { A) } & 6 \% & 6 \% \\\hline \text { B) } & 8.4 \% & 6 \% \\\hline \text { C) } & 14 \% & 10 \% \\\hline \text { D) } & 10 \% & 10 \% \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D

Question 32

Which of the following is not included in the computation of Altman's Z-score?

A) Liquidity
B) Trendline
C) Leverage
D) Profitability

Question 33

Which of the following statements are true?
I) Pre-tax cost of debt is generally higher than the pre-tax cost of equity
II) Interest is tax deductible
III) Preferred dividends are tax deductible
IV) Total cost of capital is normally less than or equal to cost of equity

A) II and IV
B) II, III and IV
C) I, II and IV
D) II only

Question 34

Which of the following statements is correct?

A) Company A has the same ROA as company B
B) Company A has a lower ROE than company B
C) Company A has same ROE as company B
D) Company A has used financial leverage to increase its return to its shareholders

Question 35

Simmons Company is in a high growth industry. You are examining its long-term solvency and notice that they have significant deferred tax liabilities. Upon further examination of the tax footnote you find that virtually all of the deferred tax liabilities are due to plant and equipment. For purposes of analysis the deferred tax liability should be treated as:

A) a liability as you do not expect it to reverse in the near future
B) a liability as you expect it to reverse in the near future
C) equity as you do not expect it to reverse in the near future
D) equity as you do expect it to reverse in the near future

Question 36

Company A capitalized $100 in interest costs during the year. Times interest earned ratio, after necessary adjustments, for Company A is:

A) 3.5
B) 2.8
C) 2.0
D) 1.2

Question 37

Two companies, A and B, both have $1million in assets, net income before interest and taxes (EBIT) of $160,000, and the same tax rate. Company A is all equity financed and B is 50% debt financed and 50% equity financed. If B's pre-tax cost of debt is 8%, then Company A will have a ROA that is ____ and a ROE that is _______ than B's. $$\begin{array} { | l | l | l | } \hline & \text { A's ROA } & \text { A's ROE } \\\hline \text { A) } & \text { higher } & \text { same } \\\hline \text { B) } & \text { higher } & \text { higher } \\\hline \text { C) } & \text { same } & \text { same } \\\hline \text { D) } & \text { same } & \text { lower } \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D

Question 38

The short-term liquidity of a company

A) is only of concern to creditors of a company
B) is determinable by looking at current ratio
C) depends largely upon prospective cash flows
D) is determinable by calculating cash to current liabilities ratio

Question 39

If a company increased its dividend payments what would happen to the following ratios, all other things being equal? $$\begin{array} { | l | l | l | l | } \hline & \text { Total Debt/Equity } & \text { Times Interest Earned } & \text { Financial Leverage Ratio } \\\hline \text { A) } & \text { Same } & \text { Same } & \text { Same } \\\hline \text { B) } & \text { Increase } & \text { Same } & \text { Decrease } \\\hline \text { C) } & \text { Same } & \text { Decrease } & \text { Decrease } \\\hline \text { D) } & \text { Increase } & \text { Same } & \text { Increase } \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D

Question 40

Which of the following is least likely to increase the overall risk of a company?

A) increased sales variability
B) increased debt levels
C) increased variable costs while decreasing fixed costs
D) increased interest rates

Question 41

Reported operating income for Horace Corporation was $145,000 and reported interest expense was $ 45,000. Times interest earned for Horace Corporation, after necessary adjustments, was:

A) 2.22
B) 3.22
C) 4.22
D) 4.48

Question 42

A primary motivation for a company financing its business activities through debt is not

A) Trading on the equity
B) Reducing earnings variability
C) Tax-deductibility of interest
D) Avoiding earnings dilution

Question 43

Typical debt covenants would
I) Limit the issuance of additional debt senior to the obligation
II) Specify minimum levels of selected financial ratios
III) Specify minimum levels of earnings coverage
IV) Prohibit excessive dividends or stock repurchases

A) II and III
B) II and IV
C) I, III and IV
D) I, II, III and IV

Question 44

The higher the company's cash to current liabilities ratio, the better is the company.

Question 45

The current ratio is a superior tool to cash flow projections and pro forma financial statements in assessing short-term liquidity.

Question 46

Liquidity depends to a large extent on prospective cash flows and to a lesser extent on the level of cash and cash equivalents.

Question 47

When considering whether an earnings coverage ratio is acceptable, consideration is least likely to be given to:

A) earnings variability
B) earnings persistence
C) cash flow variability
D) dividend policy for common stock

Question 48

If a company has a current ratio greater than one then there is no chance it will go bankrupt in the next year.

Question 49

When calculating debt to equity ratio:

A) Convertible bonds should be treated as debt
B) Convertible bonds should be excluded from debt but not included in equity
C) Convertible bonds should be treated as equity
D) Half the convertible bonds should be treated as debt, and the other half as equity

Question 50

Screening hundreds of companies for investment opportunities, you come across Apex Corp. It is rated AA by the major rating agencies and has a low Z-score. You want to do detailed analysis, but you preliminarily conclude

A) Apex debt is overvalued
B) Apex stock should appreciate over the short term
C) Apex has untapped growth potential
D) None of the above
True / False Questions

Question 51

All current assets, by definition, will result in cash inflows within the next year or operating cycle whichever is longer.

Question 52

When examining a company's current ratio it is important to also assess the quality of the current assets and liabilities.

Question 53

A company has significant uncapitalized operating leases. This company has positive net income. If these were capitalized the effect on the following ratios would be: $$\begin{array} { | l | l | l | } \hline & \text { Times interest earned } & \text { Debt/equity ratio } \\\hline \text { A) } & \text { Increase } & \text { Increase } \\\hline \text { B) } & \text { Increase } & \text { Decrease } \\\hline \text { C) } & \text { Decrease } & \text { Decrease } \\\hline \text { D) } & \text { Decrease } & \text { Increase } \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D
Horace Corporation has $200,000 of convertible 5% bonds. Each $500 bond is convertible into 50 shares of common stock. The bonds were sold at par and are currently trading at par, and the required return on nonconvertible bonds of similar risk is 11%. Common stock is trading at $ 23 per share.

Question 54

Liquidity is generally measured by the company's ability to pay its short term obligations using its short assets.

Question 55

The higher the company's cash to current liabilities ratio, the more liquid is the company.

Question 56

An increase in the credit days offered to customers by a company will improve the company's financial situation because of the likely increase in sales.

Question 57

The total leverage ratio of a company will:

A) increase if operating leases are capitalized
B) increase if a company sells its receivables
C) increase if a company sells more equity
D) increase if a company pays suppliers more quickly

Question 58

Companies in certain industries do not make the distinction between current and non-current on their balance sheets.

Question 59

Which of the following transactions or events would have no immediate effect on the times interest earned ratio but will cause debt/equity ratio to decrease?

A) issuing new debt
B) issuing new equity
C) having a stock split
D) recording large contingent liability for lawsuit

Question 60

Liquidity is viewed as the company's ability to meet its short term and long term obligations.

Question 61

The cash ratio is a measure of the degree of current asset liquidity.

Question 62

When calculating the times interest earned adjustments should normally be made for existence of operating leases. A portion of rental payments should be reclassified as interest.

Question 63

Analysis of profitability of a company is more important when considering short-term liquidity than when considering long-term solvency of a company.

Question 64

The higher the company's inventory turnover the better is company.

Question 65

If accounts payable turnover decreases this could be an indication that suppliers are cutting off credit to the company.

Question 66

Management Discussion and Analysis provides information that is useful in helping assess company's liquidity.

Question 67

For purposes of long-term solvency analysis the calculation of balance sheet ratios such as debt/equity or debt to total capital are of limited value and are used mostly as screening mechanisms to indicate whether further analysis is warranted.

Question 68

One would expect restaurants to have lower inventory turnovers than general merchandise stores.

Question 69

An increase in the current ratio over time is always a good indication of increased liquidity of the firm.

Question 70

A decrease in provision for doubtful accounts relative to gross accounts receivable could indicate improved collection of accounts receivable or it could indicate that management has failed to make adequate provisions for non-collectible accounts.

Question 71

When examining the current ratio and trends in the current ratio it is important to evaluate the turnover rate of current assets and current liabilities and trends in these turnover ratios.

Question 72

If a company's days receivables outstanding increases this could be an indication that there are problems with the quality of the company's products.

Question 73

In assessing the quality of receivables it is important to consider the revenue recognition methods used by a company.

Question 74

If a company sells its receivables this is an indication that it has very high quality receivables.

Question 75

The lower equity is as a proportion of total capital, all other things equal, the greater the risk borne by the other providers of capital.

Question 76

When calculating earnings coverage ratios it is common to remove the effects of extraordinary gains and losses and other one-time gains and losses from the numerator.

Question 77

The use of LIFO will inflate the current ratio under normal economic conditions.

Question 78

An increase in the current ratio due to increased inventory and receivables could be consistent with a recession in the economy.

Question 79

Determination of short-term liquidity is important to both investors and creditors.

Question 80

If a company switches from FIFO to LIFO during a period of rising prices, inventory turnover will probably increase.