ISM Chapter 05

Chapter 5
Risk Analysis
CHAPTER 5
RISK ANALYSIS
Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases
5.1
Interpreting the Alternative Decomposition of ROCE with Negative Financial Obligations.

Because the firm has more financial assets than financial obligations, the net financial obligations
will be negative. The reformulated balance sheet equation will still balance: Net Operating Assets
= Net Financial Obligations + Common Equity. However, Net Operating Assets will exceed
Common Equity because Net Financing Obligations are negative. In computing Operating ROA,
NOPAT will exclude any interest revenues generated by the marketable equity securities. Net
Financing Expense (after tax) will be equal to Interest Revenues (which is a negative financing
expense). The computation of Net Financing Expense will be a negative [interest revenues x (1
tax rate)], and the Net Borrowing rate will be computed as Net Financing Expense Net Financing
Obligations. Thus, mathematically the negative Net Financing Expense in the numerator and
negative Net Financing Obligations in the denominator cancel; nevertheless, the resulting
borrowing rate actually is a Net Return to Net Financial Assets and reflects the after-tax earnings
on the marketable equity securities. (The rate of return would likely be quite small.) The
computation of Leverage will be the Net Financial Obligations (which are negative) divided by
common equity; hence, Leverage will be negative. Together the alternative decomposition would
show Operating ROA being reduced by leverage because Leverage (<0) and Spread would be
(Operating ROA Net Return on Net Financial Assets). This makes sense because the firms
large returns from its operations are being dampened because the firm has capital sitting in assets
that generate inferior returns relative to the firms operating assets.
5.2
Relation between Current Ratio and Operating Cash Flow to Current Liabilities Ratio. Both
ratios use current liabilities in the denominator, although the current ratio using current liabilities at
the end of a period and the cash flow ratio uses average current liabilities for the period. Thus, the
explanation most likely relates to the numerator. The firm is probably growing and increasing
inventories and accounts receivable, which increase the current ratio. However, the firm is not
collecting cash from customers but having to pay suppliers of merchandise, which lowers cash
flow from operations.
5.3 Relation between Current Ratio and Quick Ratio. The current ratio and the quick ratio both use
current liabilities in the denominator. Thus, the explanation most likely relates to the numerator.
The only differences in the numerator are that the current ratio includes inventories and
prepayments, while the quick ratio does not. Sales growth has likely slowed or even decreased;
thus, the firm has reduced inventories and prepayments. The firm has collected cash from higher
levels of accounts receivable of the previous period before the slowdown in sales and has invested
the cash in marketable securities.
5-1
Copyright 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 5
Risk Analysis
5.4
Relation between Working Capital Turnover Ratios and Cash Flow from Operations. The
steady sales and net income should result in relatively constant addbacks for depreciation, deferred
taxes, and other non-cash expenses. The decrease in the turnover of inventory coupled with the
increase in the turnover for accounts payable means that the firm has purchased or produced
inventory that is not selling as fast as it had been, but the firm is paying for the inventory at a faster
rate than previously. These actions will reduce cash flow from operations. The decrease in the
accounts receivable turnover in light of steady sales indicates that the firm is not collecting cash
from customers as quickly as in previous periods, thereby reducing cash flow from operations.
Thus, cash flow from operations likely decreases. If sales and net income were increasing, cash
flow from operations could increase as well, but not as rapidly as sales and net income because of
the buildup of accounts receivable and inventories and the decrease in the accounts payable
turnover.
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
5-2
Chapter 5
Risk Analysis
(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.
5.6
Interest Coverage Ratio as a Measure of Long-Term Solvency Risk. The interest coverage
ratio compares net income before interest and income taxes to interest expense for the past year or
years. Firms typically declare bankruptcy because they have insufficient cash to pay bills coming
due. Thus, one assumption is that accrual-based net income accurately measures cash flow from
operations. A second assumption is that the amount of interest expense accurately measures the
required cash outflow for interest. A third assumption is that the firm does not have principal
amounts to be paid in addition to interest. Furthermore, regarding the interest coverage ratio being
an appropriate measure for long-term solvency risk, the assumption is that net income, income
taxes, and interest expense of the current period are good predictors of amounts for future periods
while long-term debt is outstanding.
5.7
Interest Coverage Ratio as a Measure of Short-Term Liquidity Risk. The interest coverage
ratio uses earnings before interest, interest expense, and income taxes of a recent period to measure
the ability of a firm to cover interest expense during that period. The amounts from the recent past
are likely good predictors of amounts of earnings, interest, and taxes coming due within the next
year or so, the period of interest when assessing short-term liquidity risk. Amounts from the recent
past are likely to be less informative about amounts five to ten years in the future, the period of
interest when assessing long-term solvency risk.
5.8
Interpreting Operating Cash Flow to Current and Total Liabilities Ratios. These results
suggest that firms meeting the minimum threshold have, on average, equal amounts of current and
noncurrent liabilities. However, we cannot determine what proportion of total financing comprises
liabilities versus shareholders equity.
5-3
Chapter 5
Risk Analysis
5.9
Interpreting Altmans Z-Score Bankruptcy Prediction Model. The coefficients are not relative
weights of importance. The size of the coefficient varies in part because of the usual size of the
variable measured. Earnings before interest and taxes as a percentage of total assets is usually
around 0.05 to 0.10, whereas sales divided by assets is usually greater than 1.0. A natural next step
would be to ask if the coefficient times the value of the variable could be viewed as a relative
weight of importance. In a mathematical sense, a bigger number for any of the five variables
increases the size of the Z-score and reduces the probability of bankruptcy. However, the
individual variables in a multivariable model cannot be viewed independently of the remaining
variables. A particular value, such as earnings before interest and taxes, can be negative and take
on a negative value when multiplied by the coefficient. This negative value does not mean the
variable is less important. In fact, it might be the most important contributing factor to a firms
bankruptcy.
5.10 Market Equity Beta in Relation to Systematic and Nonsystematic Risk. The characterization
of nonsystematic risk as firm-specific risk is a misnomer because some set of firm-specific
attributes must affect systematic risk if each firm has its own market equity beta. Empirical
research has shown a relation between: (i) market equity beta, (ii) the degree of operating and
financial leverage, and (iii) the variability of sales. These three attributes are firm-specific, yet
they affect the covariability of a firms returns with the market. (That is, they affect systematic
risk.) A more accurate description is that systematic risk includes variables affecting the
covariability of returns and that nonsystematic risk includes variables not affecting the
covariability of returns, regardless of whether the variables are firm-specific, industry-specific, or
country-specific.
5.11 Comparison of Altmans Bankruptcy Prediction Model and Beneishs Earnings
Manipulation Model. One might argue that there is no inherent advantage of a levels model over
a change model for either purpose. The models are simply what the authors introduced in their
research. However, one might more easily think of bankruptcy as a state condition; a firm gets to a
particular state in terms of lack of availability of liquid resources, debt coming due, and poor
profitability and simply cannot continue operating. On the other hand, managers are more likely to
engage in earnings manipulation when profitability and risk ratios take a turn for the worse;
investors expect the firm to at least maintain the status quo of the previous period with regard to
profitability and risk profile. When conditions worsen, management may take actions outside
GAAP to fix the appearance of deterioration. Thus, a model emphasizing changes captures the
deteriorating situation.
5-4
Chapter 5
Risk Analysis
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
5-5
Chapter 5
Risk Analysis
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. Hasbros long-term solvency risk has decreased significantly during the three-year period.
Debt levels have declined as Hasbro has redeemed debt. (See Hasbros 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.
5.13 Calculating and Interpreting Risk Ratios.
a. Revenues to Cash Ratio: $2,021/.5($56 + $350) = 10.0
Days Revenues in Cash: 365/10 = 37 days
Current Ratio: $652/$414 = 1.6
Quick Ratio: ($350 + $26)/$414 = .9
Days Accounts Receivable: $2,021/.5($7 + $26) = 122.5; 365/122.5 = 3 days
Days Inventory: $1,048/.5($201 + $248) = 4.7; 365/4.7 = 78 days
($1,048 + $248 $201)/[.5($58 + $84)] = 15.4;
365/15.4 = 24 days
$426/[.5($311 + $414)] = 1.175
Liabilities to Assets Ratio: $1,551/$2,220 = 0.699
Liabilities to Shareholders Equity Ratio: $1,551/$669 = 2.318
$872/($872 + $669) = 0.566
Long-Term Debt to Shareholders Equity Ratio: $872/$669 = 1.303
$426/[.5($1,238 + $1,551)] = 0.305
Interest Coverage Ratio: ($216 + $63 + $137)/$63 = 6.6
b. The short-term liquidity risk of Abercrombie & Fitch appears low, although it deteriorated
between fiscal Year 4 and fiscal Year 5. Using cash to measure only the revenues to cash and
days revenues in cash ratios is probably not appropriate in this case because of the substantial
holding of marketable securities. If we recompute these ratios to include marketable securities,
the revenues to cash ratio is 4.8 in fiscal Year 3 (76 days), 3.6 in fiscal Year 4 (101 days), and
4.6 in fiscal Year 5 (79 days). These appear to be very healthy ratios from the viewpoint of
short-term liquidity risk. The current and quick ratios are at healthy levels as well, although
both ratios declined sharply in fiscal Year 5. The decline occurs because of a decline in cash
and marketable securities, additional short-term borrowing, and a stretching out of payments to
suppliers. Despite the additional short-term borrowing and stretching of payments to suppliers,
5-6
Chapter 5
Risk Analysis
the operating cash flow to current liabilities ratio remained steady and well above the 40
percent threshold for a healthy company. The one worrisome trend is the increase in the
number of days inventory is held. The products of Abercrombie & Fitch are trendy. A buildup
of inventory is undesirable. However, the increase in days inventory may be simply due to
stocking the rapid growth in new stores.
c. The long-term solvency risk of Abercrombie & Fitch appears to be moderate and worsened
between Year 4 and Year 5. The debt ratios are on the high side at the end of fiscal Year 3 and
fiscal Year 4 and are even higher at the end of fiscal Year 5. Abercrombie & Fitch took on
more short- and long-term debt in Year 5. It also made a major repurchase of its common
stock (see the statement of cash flows in Exhibit 4.34), further elevating the debt ratios.
However, the operating cash flow to total liabilities ratio is well above the 20 percent threshold
for a healthy company; its interest coverage ratio is healthy as well. Thus, despite the heavy
debt load, Abercrombie & Fitch appears able to service this debt at this time.
5.14 Interpreting Risk Ratios.

a. Coca-Colas short-term liquidity risk is low and did not change significantly during the threeyear period. Cash relative to revenues decreased in 2007, but increased in 2008 to levels
similar to 2006 and a similar pattern of days of revenues in cash. From the viewpoint of shortterm liquidity risk, these ratios suggest declining risk. Its current ratio is just below 1.0, and its
quick ratio is below 0.6 but has remained steady over the past three years. The operating cash
flow to current liabilities ratio has been decreasing, but it remains above the desired level of 40
percent. This is not too worrisome given that the firm has a demonstrated ability to sell
products for considerably more than their book value.
b. Coca-Colas long-term solvency risk decreased during the three-year period. Its debt ratios
generally declined, particularly its long-term debt ratios. Operating cash flow to total liabilities
and interest coverage ratios decreased, but are still above a desirable level due to Coca-Colas
profitability. The overall level of long-term solvency risk is still low.
5-7
Chapter 5
Risk Analysis
c. Amounts shown for PepsiCo throughout the chapter are consolidated into the following table:
Revenues to Cash Ratio ..........

Days Revenues in Cash ...........
Current Ratio ...........................
Quick Ratio .............................
Operating Cash Flow to Average Current Liabilities
Ratio .....................................
Days Accounts Receivable .....
Days Inventory ........................
Days Accounts Payable...........
Net Days Working Capital ......
Liabilities to Assets Ratio .......
Liabilities to Shareholders
Equity Ratio .........................
Long-Term Debt to LongTerm Capital Ratio ...............
Long-Term Debt to Shareholders Equity Ratio ...........
Operating Cash Flow to
Average Total Liabilities
Ratio .....................................
Interest Coverage Ratio...........
PepsiCo
2008
29.1
17.5
1.2
0.8
2008
6.9
53
0.9
0.6
Coca-Cola
2007
8.4
44
0.9
0.6
0.850
38
43
48
34
0.664
0.578
37
71
44
64
0.495
0.647
37
68
38
67
0.497
0.636
37
68
40
65
0.435
1.973
0.979
0.990
0.771
0.394
0.120
0.131
0.072
0.649
0.136
0.151
0.078
0.339
22.3
0.364
17.0
0.414
17.3
0.456
29.9
2006
6.5
56
0.9
0.6
Coca-Cola appears to have slightly more short-term liquidity risk compared to PepsiCo, but
neither company has much risk in this regard. Coca-Cola has more cash on the balance sheet
relative to revenues and therefore a larger number of days revenues in cash. While this is
desirable in terms of short-term liquidity risk, it might suggest that Coca-Cola does not have
attractive investment alternatives. PepsiCo has a much higher revenues to cash ratio, but this is
due to the lower cash holdings. The current and quick ratios of the two firms are similar. The
operating cash flow to current liabilities ratio for both firms is well above the desired level of
0.40, with PepsiCo having a higher ratio. The two firms have similar days accounts receivable
outstanding. Coca-Colas days inventory is approximately 28 days longer than PepsiCos.
Part of the lower days inventory for PepsiCo is the faster turnover necessary for snack foods.
5-8
Chapter 5
Risk Analysis
d. Neither PepsiCo nor Coca-Cola displays much long-term solvency risk. However, PepsiCo
appears to have somewhat higher long-term solvency risk than Coca-Cola does. PepsiCo
carries a higher proportion of liabilities in its capital structure compared to Coca-Cola, due
primarily to a higher proportion of long-term debt. Both firms have operating cash flow to
total liabilities above the 0.20 desired level and very high interest coverage ratios, although the
ratios for Coca-Cola exceed those for PepsiCo.
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)

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)

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)
5-9
Chapter 5
Risk Analysis
(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. Altmans Z-Score
2000
Working Capital/Assets: 1.2[($3,205 $5,245)/$21,931] ....................
Retained Earnings/Assets: 1.4($4,176/$21,931) ...................................
EBIT/Assets: 3.3($1,829/$21,931) .......................................................
Mkt. Value Equity/Liabilities: .6[(123 x $50.185)/$16,354] ................
Sales/Assets: 1.0($15,657/$21,931)......................................................
Z-Score ................................................................................................
(.112)
.267
.275
.226
.714
1.370
Probability of Bankruptcy ......................................................................
35.5%
2001
EBIT/Assets: 3.3($1,365/$23,605) .....................................................
Mkt. Value Equity/Liabilities: .6[(123 x $29.26)/$19,581] ..................
Sales/Assets: 1.0($13,879/$23,605) ......................................................
Z-Score ................................................................................................
(.144)
.174
(.191)
.110
.588
.537
67.8%
2002
EBIT/Assets: 3.3($1,337/$24,720) .....................................................
Mkt. Value Equity/Liabilities: .6[(123.4 x $12.10)/$23,563] ...............
Sales/Assets: 1.0($13,866/$24,720) ......................................................
Z-Score ................................................................................................
(.124)
.093
(.178)
.038
.561
.390
72.9%
2003
Retained Earnings/Assets: 1.4($844/$25,939) ......................................
EBIT/Assets: 3.3($432/$25,939) ........................................................
Mkt. Value Equity/Liabilities: .6[(123.5 x $11.81)/$26,323] ...............
Sales/Assets: 1.0($14,087/$25,939) ......................................................
Z-Score ................................................................................................
(.074)
.046
(.055)
.033
.543
.493
69.4%
5-10
Chapter 5
Risk Analysis
2004
Retained Earnings/Assets: 1.4($4,373/$21,801) .................................
EBIT/Assets: 3.3($3,168/$21,801) .....................................................
Mkt. Value Equity/Liabilities: .6[(139.8 x $7.48)/$27,320] .................
Sales/Assets: 1.0($15,002/$21,801) ......................................................
Z-Score ................................................................................................
(.129)
(.281)
(.480)
.023
.688
(.179)
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.
5.16 Calculating and Interpreting Risk and Bankruptcy Prediction Ratios for a Firm That Was
Acquired.
a. (1) Current Ratio:
2005: $7,191/$4,766 = 1.51
2005: $8,460/$6,165 = 1.37
2007: $9,328/$5,451 = 1.71
2008: $7,834/$5,668 = 1.38
2009: $6,864/$5,621 = 1.22
(2)

2006: $567/.5($4,766 + $6,165) = 0.104
2007: $958/.5($6,165 + $5,451) = 0.165
2008: $1,329/.5($5,451 + $5,668) = 0.239
2009: $457/.5($5,668 + $5,621) = 0.081
5-11
Chapter 5
Risk Analysis
(3)
Liabilities to Assets Ratio:

2005: $7,516/$14,190 = 0.530
2006: $8,738/$15,082 = 0.579
2007: $8,659/$15,838 = 0.547
2008: $8,752/$14,340 = 0.610
2009: $7,927/$11,232 = 0.706
(4)
Long-Term Debt to Long-Term Capital Ratio:

2005: $1,123/($1,123 + $6,674) = 0.144
2006: $575/($575 + $6,344) = 0.083
2007: $1,264/($1,264 + $7,179) = 0.150
2008: $1,265/($1,265 + $5,588) = 0.185
2009: $695/($695 + $3,305) = 0.174
(5)

2006: $567/0.5($7,516 + $8,738) = 0.070
2007: $958/0.5($8,738 + $8,659) = 0.110
2008: $1,329/0.5($8,659 + $8,752) = 0.153
2009: $457/0.5($8,752 + $7,927) = 0.055
(6)
Interest Coverage Ratio:

2005, 2006, and 2009: The interest coverage ratio is negative and
therefore is not covered.
2007: $622/$39 = 15.9
2008: $640/$30 = 21.3
b. Altmans Z-Score
2005
EBIT/Assets: 3.3[$(150)/$14,190]........................................................
Mkt. Value Equity/Liabilities: .6[(852 x $14.92)/$7,516] ....................
Sales/Assets: 1.0($11,070/$14,190) ......................................................
Z-Score ................................................................................................
.205
.137
(.035)
1.015
.780
2.102
13.5%
2006
Retained Earnings/Assets: 1.4[$(257)/$15,082] ...................................
EBIT/Assets: 3.3[($(620)/$15,082] ......................................................
Sales/Assets: 1.0($13,068/$15,082) ......................................................
Z-Score ................................................................................................
.183
(.024)
(.136)
.998
.866
1.888
18.7%
5-12
Chapter 5
Risk Analysis
2007
Retained Earnings/Assets: 1.4($189/$15,838) ......................................
EBIT/Assets: 3.3($622/$15,838) ..........................................................
Sales/Assets: 1.0($13,873/$15,838) ......................................................
Z-Score ................................................................................................
.294
.017
.130
1.271
.876
2.587
5.6%
2008
Retained Earnings/Assets: 1.4($430/$14,340)......................................
EBIT/Assets: 3.3($640/$14,340) ..........................................................
Sales/Assets: 1.0($13,880/$14,340) ......................................................
Z-Score ................................................................................................
.181
.042
.147
.561
.968
1.899
18.4%
2009
Retained Earnings/Assets: 1.4[$(2,055)/$11,232] ................................
EBIT/Assets: 3.3[$(2,166)/$11,232].....................................................
Mkt. Value Equity/Liabilities: .6[(752 x $9.22)/$7,927] ......................
Sales/Assets: 1.0($11,449/$11,232) ......................................................
Z-Score ................................................................................................
.133
(.256)
(.636)
.525
1.019
.784
58.5%
c. Sun Microsystems problems were primarily operating and not financing despite fluctuating
debt levels and an increase in liabilities to assets. Firms in technology-based industries tend
not to take on substantial debt, particularly long-term debt. Such firms have short product life
cycles and few assets to serve as collateral for borrowing. The deterioration of interest
coverage ratio in 2009 was due to the lack of earnings and cash flows from operations and not
from being overly burdened with debt. The firm appeared to recover from poor profitability in
2007, but experienced another significant decrease in profitability and cash flow in 2009.
Current liabilities to current assets and total liabilities to total assets increased in 2009. The
operating problems caused its Z-score to drop from the gray to the high-probability area in
2009. As stated in the question, Sun did not go bankrupt, but the company was acquired by
Oracle in 2010. This problem highlights the fact that bankruptcy predication models also may
be useful in predicting takeover targets.
5-13
Chapter 5
Risk Analysis
5.17 Computing and Interpreting Bankruptcy Prediction Ratios:

a. Altmans Z-Score for Best Buy
2006
EBIT/Assets: 3.3($2,161/$13,570) .......................................................
Sales/Assets: 1.0($35,934/$13,570) ......................................................
Z-Score ................................................................................................
.246
.568
.526
1.760
2.648
5.747
0.0%
2007
EBIT/Assets: 3.3($2,290/$12,758) .......................................................
Mkt. Value Equity/Liabilities: .6[(411 x $42)/$8,274] .........................
Sales/Assets: 1.0($40,023/$12,758) ......................................................
Z-Score ................................................................................................
.054
.432
.592
1.252
3.137
5.467
0.0%
Altmans Z-Score for Circuit City

2006
Working Capital/Assets: 1.2[($2,884 $1,714)/$4,007] ......................
Retained Earnings/Assets: 1.4($1,336/$4,007) .....................................
EBIT/Assets: 3.3($22/$4,007) ..............................................................
Sales/Assets: 1.0($12,430/$4,007) ........................................................
Z-Score ................................................................................................
.350
.467
.018
.854
3.102
4.790
0.0%
2007
Working Capital/Assets: 1.2[($2,440 $1,606)/$3,746] ......................
Retained Earnings/Assets: 1.4($981/$3,746) ........................................
EBIT/Assets: 3.3[$(352)/$3,746]..........................................................
Mkt. Value Equity/Liabilities: .6[(169 x $4.38)/$2,243] ......................
Sales/Assets: 1.0($11,744/$3,746) ........................................................
Z-Score ................................................................................................
.267
.367
(.310)
.198
3.135
3.656
0.0%
5-14
Chapter 5
Risk Analysis
b. The Z-scores of Best Buy were in the range indicating a low probability of bankruptcy in both
years. High profitability and high turnover explain the high Z-scores. The increase in the Zscore between 2006 and 2007 results from an increase in the EBIT to assets ratio. The increase
in asset turnover is consistent with Best Buys supply chain transformation and inventory
management. The new strategy focuses on pinpointing customer needs rather than pushing
large volumes.
c. The Z-scores of Circuit City also were in the range indicating a low probability of bankruptcy
in both years. The firms net income was negative in both years and decreased significantly
between 2006 and 2007. Retained earnings were positive in both years, but decreased, as did
current and total assets. The decrease in retained earnings and negative EBIT are a principal
factor accounting for the firms Z-score falling, but because assets also have declined, the Zscore remains in the low probability of bankruptcy area.
d. The Z-scores did not predict that Circuit City or Best Buy would file for bankruptcy in 2008.
The Z-scores of Circuit City were lower; thus, its probability of bankruptcy was technically
higher than what the corresponding Z-scores of Best Buy showed. Three positive signals for
Best Buy included (1) a sales increase between 2006 and 2007, in contrast to the sales decrease
for Circuit City; (2) a higher asset turnover for Best Buy; and (3) a much higher market
capitalization for Best Buy compared to Circuit City. Despite the high Z-scores, the crash of
Circuit Citys market price per common share between 2007 and 2008 suggested that the
market perceived the firms problems as not correctable or that there were other indicators of
bankruptcy than those captured by the Altman Z-score.
5.18 Applying and Interpreting Bankruptcy Prediction Models.

a. Altmans Z-Score for Harvard Industries
Year 5
Working Capital/Assets: 1.2[($195,417 $176,000)/$662,262] ..........
Retained Earnings/Assets: 1.4($115,596/$662,262) ...........................
EBIT/Assets: 3.3($40,258/$662,262) ...................................................
Mkt. Value Equity/Liabilities: .6[(6,995 x $100.50)/$624,817] ...........
Sales/Assets: 1.0($631,832/$662,262) ..................................................
Z-Score ................................................................................................
.035
(.244)
.201
.675
.954
1.621
26.7%
5-15
Chapter 5
Risk Analysis
Year 6
Retained Earnings/Assets: 1.4($184,308/$617,705)...........................
EBIT/Assets: 3.3($11,012/$617,705) .................................................
Mkt. Value Equity/Liabilities: .6[(7,014 x $85)/$648,934] ..................
Sales/Assets: 1.0($824,835/$617,705) ..................................................
Z-Score ................................................................................................
(.014)
(.418)
(.059)
.551
1.335
1.395
34.6%
Altmans Z-Score for Marvel Entertainment

Year 5
Working Capital/Assets: 1.2[($490,600 $318,100)/$1,226,310] .......
Retained Earnings/Assets: 1.4($114,100/$1,226,310) ..........................
EBIT/Assets: 3.3($25,100/$1,226,310) ................................................
Mkt. Value Equity/Liabilities: .6[(101,703 x $10.625)/$948,100] .......
Sales/Assets: 1.0($828,900/$1,226,310) ...............................................
Z-Score ................................................................................................
.169
.130
.068
.684
.676
1.727
23.4%
Year 6
Retained Earnings/Assets: 1.4($350,300/$844,000) ...........................
EBIT/Assets: 3.3($370,200/$844,000) ...............................................
Mkt. Value Equity/Liabilities: .6[(101,810 x $1.625)/$999,700] .........
Sales/Assets: 1.0($745,400/$844,000) ..................................................
Z-Score ................................................................................................
.076
(.581)
(1.447)
.099
.883
(.970)
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 firms Z-score falling in the high probability of bankruptcy range. The Zscore 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.
5-16
Chapter 5
Risk Analysis
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 firms 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.
5.19 Applying and Interpreting Bankruptcy Prediction Models.

a. Altmans Z-Score for Tribune Company
2006
EBIT/Assets: 3.3($1,085/$13,401) .......................................................
Sales/Assets: 1.0($5,444/$13,401) ........................................................
Z-Score ................................................................................................
2007
Retained Earnings/Assets: 1.4[$(3,474)/$13,150] ................................
EBIT/Assets: 3.3($619/$13,150) ..........................................................
Mkt. Value Equity/Liabilities: .6[(239 x $45.04)/$16,664] ..................
Sales/Assets: 1.0($5,063/$13,150) ........................................................
Z-Score ................................................................................................
(.108)
.328
.267
1.190
.406
2.083
13.9%
(.073)
(.370)
.155
.388
.385
.485
69.7%
5-17
Chapter 5
Risk Analysis
Altmans Z-Score for Washington Post

2006
Working Capital/Assets: 1.2[($935 $812)/$5,381] ............................
EBIT/Assets: 3.3($544/$5,381) ............................................................
Sales/Assets: 1.0($3,905/$5,381)..........................................................
Z-Score ................................................................................................
.027
1.072
.334
1.921
.726
4.080
.1%
2007
Working Capital/Assets: 1.2[($995 $1,013)/$6,005] .........................
EBIT/Assets: 3.3($505/$6,005) ............................................................
Sales/Assets: 1.0($4,180/$6,005) ..........................................................
Z-Score ................................................................................................
(.004)
1.010
.278
1.791
.696
3.771
.4%
b. Altmans Z-score model indicates an increasing probability of bankruptcy for Tribune

Company. The Z-score increased significantly between 2006 and 2007. The Z-score is in the
high probability of bankruptcy area in 2007. The change in Z-score is largely due to lower
earnings, higher liabilities, and a reduced stock price. However, the MVE/Liabilities and
RE/Assets components signal a serious bankruptcy risk.
c. Altmans Z-score model indicates a low probability of bankruptcy for Washington Post in both
years. Three positive signals for Washington Post include (1) a sales increase between 2006
and 2007, (2) an increase in retained earnings, and (3) an increasing market price per common
share. The Z-score has decreased slightly due to a small decrease in working capital.
d. Altmans bankruptcy prediction model suggested that there was a high probability that the
Tribune Company would file for bankruptcy in 2008. There was very low probability that
Washington Post would file for bankruptcy in 2008. Even though Tribune Company had assets
greater than two times Washington Posts assets, Tribune Company had lower income and
significantly lower retained earnings. The Tribune Company had a larger asset base and thus a
very poor asset turnover ratio compared to that of Washington Post.
5-18
Chapter 5
Risk Analysis
5.20 Applying and Interpreting the Earnings Manipulation Model.

a. 1998
Constant .................................................................................................
DSRI: .920[($2,060/$31,260)/($1,697/$20,273)] .................................
GMI: .528[{($20,273 $17,311)/$20,273}/{($31,260 $26,381)/
$31,260}] .........................................................................................
AQI: .404[{1 (($5,933 + $10,657)/$29,350)}/{1 (($4,669 +
$9,170)/$23,422)}] ..........................................................................
SGI: .892($31,260/$20,273) .................................................................
DEPI: .115[{$480/($480 + $9,170)}/{$563/($563 + $10,657)}] .........
SAI: .172[($2,473/$31,260)/($1,406/$20,273)] ..................................
LVGI: .327 [{($6,107 + $7,357)/$29,350}/{($4,412 + $6,254)/
$23,422}] .........................................................................................
TATA: 4.679[($703 $1,640)/$29,350] ..............................................
Value of y ...............................................................................................
Probability of Manipulation ...................................................................
1999
Constant .................................................................................................
DSRI: .920[($3,030/$40,112)/($2,060/$31,260)] .................................
GMI: .528[{($31,260 $26,381)/$31,260}/{($40,112 $34,761)/
$40,112}] .........................................................................................
AQI: .404[{1 (($7,255 + $10,681)/$33,381)}/{1 (($5,933 +
$10,657)/$29,350)}] ........................................................................
SGI: .892($40,112/$31,260) .................................................................
DEPI: .115[{$563/($563 + $10,657)}/{$565/($565 + $10,681)}] .......
SAI: .172[($3,045/$40,112)/($2,473/$31,260)] ..................................
LVGI: .327[{($6,759 + $7,151)/$33,381}/{($6,107 + $7,357)/
$29,350}] .........................................................................................
TATA: 4.679[($1,024 $1,228)/$33,381] ...........................................
Value of y ...............................................................................................
4.840
.724
.494
.429
1.375
.114
.196
.329
.149
2.378
.9%
4.840
1.055
.618
.430
1.144
.115
.165
.297
.029
1.969
2.4%
5-19
Chapter 5
Risk Analysis
2000
Constant .................................................................................................
DSRI: .920[($10,396/$100,789)/($3,030/$40,112)] .............................
GMI: .528[{($40,112 $34,761)/$40,112}/{($100,789 $94,517)/
$100,789}] .......................................................................................
AQI: .404[{1 (($30,381 + $11,743)/$65,503)}/
{1 (($7,255 + $10,681)/$33,381)}] ...............................................
SGI: .892($100,789/$40,112) ...............................................................
DEPI: .115[{$565/($565 + $10,681)}/{$485/($485 + $11,743)}] .......
SAI: .172[($3,184/$100,789)/($3,045/$40,112)] ................................
LVGI: .327[{($28,406 + $8,550)/$65,503}/{($6,759 + $7,151)/
$33,381}] .........................................................................................
TATA: 4.679 [($979 $4,779)/$65,503] .............................................
Value of y ...............................................................................................
4.840
1.256
1.132
.312
2.241
.146
.072
.443
.271
.539
29.5%
b. The probability of manipulation increased over the three years. Note, however, that the
probabilities of .9 percent for 1998 and 2.4 percent for 1999 are below the probability cutoff
value of 2.94 percent for a relative Type I to Type II error of 40 to 1 or higher. The probability
of manipulation did not exceed this cutoff value until 2000. In that year, the probability of
manipulation of 29.5 percent exceeded the cutoff probability value for relative Type I to Type
II error rates of 10 to 1 or more. The most important contributing factors were as follows:
1. DSRI: The days receivables outstanding variable steadily increased, indicating that
receivables were an increasing percentage of sales. Enron may have offered more liberal
repayment terms, inadequately provided for uncollectible accounts, or increased accounts
receivable and sales for bogus transactions.
2. GMI: The gross margin index steadily increased, which indicates that the gross margin
percentage steadily decreased. Enron moved from distribution of higher margin fuels and
electric power to lower margin energy derivatives during this period. Its squeezed gross
margin may have led to the need to create earnings in other ways.
3. SGI: The sales growth index exceeded 1.0 each year, indicating growing sales. The sales
growth rate for 1998 exceeded that of 1997, and the sales growth rate for 2000 exceeded
that of 1999. The need to maintain sales growth rates may have led Enron to recognize
bogus sales.
4. DEPI: The depreciation index increased between 1999 and 2000. Although property,
plant, and equipment increased between 1999 and 2000, depreciation decreased. Enron
may have lengthened useful lives as a means of enhancing earnings.
5-20
Chapter 5
Risk Analysis
5. SAI: The selling and administrative expense index decreased steadily during the three
years. SAI has a negative coefficient, so the decrease in this index causes the value of y
to decrease (that is, become less negative) and increases the probability of bankruptcy.
Beneishs interpretation of such a change is that the firm may have capitalized expenditures
it should have treated as expenses.
5.21 Reformulating Financial Statements, Preparing an Alternative Decomposition of ROCE, and

Assessing Financial Flexibility.
a. ROCE: $114,524/.5($1,506,024 + $1,458,804) = 7.73%
b. Effective Tax Rate: $91,995/$206,519 = 44.55%
NOPAT: ($236,238 + $6,697) x (1 44.55%) = 134,718
Net Financing Expense (after tax): $36,416 x (1 44.55%) = $20,194
Operating Profit Margin: $134,718/$7,953,912 = 1.69%
Net Operating Assets Turnover: $7,953,912/.5($2,435,194 + $2,219,672)
= 3.42
Operating ROA: $134,718/.5($2,435,194 + $2,219,672) = 5.79%
Leverage: .5($929,170 + $760,868)/.5($1,506,024 + $1,458,804) = 0.57
Spread: 5.79% [$20,194/.5($929,170 + $760,868)] = 5.79% 2.39% = 3.40%
ROCE = Operating ROA + Leverage x Spread
= 5.79% + (0.57 x 3.40%) = 7.73%
c. NOPAT: $236,238 x (1 44.55%) = 131,005
Net Financing Expense (after tax): ($36,416 $6,697) x (1 44.55%)
= $16,481
Operating Profit Margin: $131,005/$7,953,912 = 1.65%
Net Operating Assets Turnover: $7,953,912/.5($2,603,678 + $2,369,914)
= 3.20
Operating ROA: $131,005/.5($2,603,678 + $2,369,914) = 5.27%
Leverage: .5($1,097,654 + $911,110)/.5($1,506,024 + $1,458,804) = 0.68
Spread: 5.27% [$16,481/.5($1,097,654 + $911,110)] = 5.27% 5.27%
1.64% = 3.63%
ROCE = Operating ROA + Leverage x Spread
= 5.27% + (0.678 x 3.63%) = 7.73%
5-21
Chapter 5
Risk Analysis
d. The inferences under either treatment are that the company has a relatively low Operating
ROA, modest Leverage, and small Spread. Compare these numbers to those of PepsiCo in
Exhibit 5.6: Operating ROA = 34.8%, Leverage = 0.41, and Spread = 21.7%. The second
approach results in an increase in Leverage due to the classification of an additional $199
million as debt, which is only slightly offset by the inclusion of $31 million as financial assets
that net against financial obligations. However, note that the reclassification in the second
approach is not accompanied by an increase in interest expense because all interest expense
was included in the first approach. The netting of $6.7 million of Investment and other income
($3.7 million after tax) against interest expense decreases the Net Borrowing Rate (from 2.39
percent to 1.64 percent), which increases the Spread. As noted, most of these differences are
relatively minor. For most firms, the analyst need not stress about the correct classification
of financial assets and liabilities. Of course, for firms with significant financial assets or
significant liabilities that could be construed to be financing obligations, the classification
tends to be more important.
5-22
Chapter 5
Risk Analysis
Integrative Case 5.1: Starbucks

a. Revenues to Cash Ratio: $10,383/.5(269.8 + $281.3) = 37.7
Days Revenues in Cash: 365/37.7 = 10 days
Current Ratio: $1,748/$2,189.7 = 0.8
Quick Ratio: ($269.8 + $52.5 + $329.5)/$2,189.7 = .3
$1,258.7/.5($2,155.6 + $2,189.7) = 0.579
Days Accounts Receivable:
$1,611/.5($287.9 + $329.5) = 5.2; 365/5.2 = 70 days
Days Inventory: $4,645.3/.5($691.7 + $692.8) = 6.7; 365/6.7 = 54 days
($4,645.3 + $692.8 $691.7)/[.5($390.8 + $324.9)] = 13.0; 365/13.0 = 28 days
Liabilities to Assets Ratio: $3,181.7/$5,672.6 = 0.561
Liabilities to Shareholders Equity Ratio: $3,181.7/$2,490.9 = 1.277
$549.6/($549.6 + $2,490.9) = 0.181
Long-Term Debt to Shareholders Equity Ratio: $549.6/$2,490.9 = 0.221
$1,258.7/[.5($3,059.8 + $3,181.7)] = 0.403
Interest Coverage Ratio: ($459.5 + $53.4)/$53.4 = 9.6
Altmans Z-Score
Working Capital/Assets: 1.2[($1,748 $2,189.7)/$5,672.6] ....................
Retained Earnings/Assets: 1.4($2,402.4/$5,672.6) ...................................
Earnings before Interest and Taxes/Assets:
3.3[($459.5 + $53.4)/$5,672.6] ..............................................................
Market Value Equity to Book Value of Debt:
.6[(735.5 x $14.17)/$3,181.7] ................................................................
Sales/Assets: 1.0($10,383/$5,672.6) .........................................................
Z-Score ...................................................................................................
1.965
1.830
4.594
Probability of Bankruptcy ..........................................................................
0.0%
(.093)
.593
.298
5-23
Chapter 5
Risk Analysis
Beneishs Earnings Manipulation Score

Days in Receivables Index:
.920[($5,672.6/$10,383)($5,343.9/$9,411.5)] .......................................
.885
Gross Margin Index: .528[($9,411.5 $3,999.1)/$9,411.5)]/[($10,383
$4,645.3)/$10,383] ..............................................................................
.549
Asset Quality Index: .404[($5,672.4 $1,748 $302.6 $2,956.4)/
$5,672.4]/[($5,343.9 $1,696.5 $258.8 $2,890.4)/$5,343.9] ..........
.508
Sales Growth Index: .892($10,383/$9,411.5) ...........................................
.984
Depreciation Index: .115[$2,416.1/($2,890.4 + $2,416.1)]/[$2,760.9/
($2,956.4 + $2,760.9)] ...........................................................................
.108
Selling and Administrative Index: .172[($1,335.4/$10,383)/
($1,250.5/$9,411.5)] ..............................................................................
(.166)
Leverage Index: .327[($2,189.7 + $549.6)/$5,672.6]/[($2,155.6 +
$550.1)/$5,343.95] .................................................................................
(.312)
Total Accruals to Total Assets: 4.670[($315.5 $1,258.7)/$5,672.6] ......
(.776)
Constant ...................................................................................................... (4.840)
Value of y ................................................................................................... (3.059)
Probability of Earnings Manipulation ........................................................
0.1%
b. Short-Term Liquidity Risk: Starbucks displays increasing short-term liquidity risk. Its current
ratio dropped below 1.0 and its quick ratio is above .3 in 2008. Both ratios have trended
downward during the three-year period. The operating cash flow to current liabilities ratio has
likewise trended downward and has dropped to the 40 percent level desired for a healthy
company. However, Starbucks has decreased the days accounts payable that are outstanding,
which may be one reason for the declining cash balance. Starbucks marketable securities
balance also has decreased considerably, which decreases its short-term liquidity.
Long-Term Solvency Risk: Starbucks total liabilities have increased during the last three years,
and its long-term debt ratios have increased significantly. Current liabilities also have increased.
The operating cash flow to total liabilities ratio and its interest coverage ratio have decreased
dramatically. While the ratios are still in the healthy range, the magnitude of the decline is
extreme. Starbucks also began to carry a material amount of long-term debt in 2007. The
reported amounts for long-term debt do not include commitments under operating leases.
Including these in long-term debt would further increase the debt levels.
Bankruptcy Risk: Altmans Z-score model shows virtually no probability of bankruptcy even
though the Z-score has declined. A large part of the declining Z-score is due to the negative
working capital and the decrease in earnings.
Earnings Manipulation Risk: Beneishs earnings manipulation model shows very low
probability of earnings manipulation for Starbucks. Assets and sales are growing despite a
decrease in net income.
5-24
Chapter 5
Risk Analysis
Case 5.2: Massachusetts Stove CompanyBank Lending Decision

I.
Objectives
A.
Apply tools for analyzing credit risk in a bank lending decision.
B.
Introduce pro forma financial statements and illustrate their use in assessing the ability of a
firm to repay short-term borrowing.
C.
Illustrate how industry factors and a firm's competitive positioning affect its ability to
generate earnings and cash flows.
II.
Teaching Strategy
You may teach this case following at least two different approaches. One approach is to ask
students to list the positive and negative factors affecting the desirability of the bank loan. When
the list is complete, have students vote on whether they would make the loan. Ask several students
on each side to summarize the most important factors in their decision. Also ask those students
who voted against making the loan whether the loan conditions (amount, repayment terms, interest
rate, collateral) could be altered in some way so that they would be willing to make the loan. A
second approach is to have the students apply the Cs of credit analysis to Massachusetts Stove
Company. This approach adds structure to the discussion and provides students with a framework
to apply to other lending decisions. The factors discussed under each of these two approaches
should be the same. After completing the discussion of the Cs, ask for a vote and discuss
students reasoning as under the first approach. You may or may not want to introduce pro forma
financial statements at this point in the course. Chapter 10 discusses and illustrates the preparation
of pro forma financial statements. You may find it useful to illustrate how the analyst uses a
spreadsheet of the pro forma financial statements to assess the sensitivity of the financial statement
amounts to changes in the assumptions made. Students need not have studied the preparation of
pro forma financial statements to appreciate their richness as a tool of analysis.
III.
Case Discussion
We use the version of the Cs of credit analysis presented in the chapter.
A.
Circumstances Leading to Need for the Loan: The case indicates that the firm needs the
loan to finance working capital related to a 25 percent projected growth in sales, to repay
suppliers, and to provide funds for expected nonrecurring legal and retooling costs. The
largest working capital need appears to be related to increased investment in inventories.
The firm is already stretching its creditors for 122 days. Its stated desire to repay
creditors suggests that suppliers are putting some pressure on the firm to reduce the days
payable. It appears that Massachusetts Stove Company has repaid bank borrowing rather
than its suppliers. Thus, part of the loan is needed to fix a cash flow problem. The other
part of the loan is needed to pay legal costs on a lawsuit whose outcome is uncertain and for
tooling costs that will not likely result in marketable collateral. Thus, considerable risk
exists with respect to the intended use of the loan proceeds.
B.
Credit: The firm has an ongoing relationship with its bank, having reduced its borrowing
during the preceding four years. Thus, it appears to have established credit.
5-25
Chapter 5
Risk Analysis
C.
Cash Flows: The bank prefers that the company generate sufficient cash flows from
operations to fund capital expenditures and repay the loan. It is generally less desirable for
the bank to have to sell the collateral to repay the loan. The projected financial statements
suggest that the company will have sufficient cash to repay the bank loan without adversely
affecting operations and capital expenditures. Students should question the assumed growth
rate in sales of 25 percent each year. This growth rate exceeds the growth rate in sales for
Year 10 and Year 11, although it is in line with the upward trend in sales growth of those
years. The sales growth assumes that other wood-stove companies will not move
aggressively into retail direct marketing and erode the position of Massachusetts Stove
Company. Barriers to entry include obtaining a customer list and investing in the necessary
communication technology. The projected amounts for cash are sensitive to the assumption
about the growth in sales. The amounts of cash on the balance sheet on December 31, Year
12 and Year 13, for different growth rates in sales are as follows:
December 31, December 31,
Growth Rate in Sales

10% .............................................................
15% .............................................................
20% .............................................................
25% .............................................................
Year 12
$ (1,306)
$ 2,892
$ 7,090
$ 11,289
Year 13
$ 34,676
$ 24,975
$ 15,587
$ 6,512
Regardless of the growth rate in sales, it appears that the firm will have sufficient cash to
repay the bank loan.
The company has reduced its days accounts receivable, inventory, and accounts payable
during the last three years. Thus, maintaining the current rates of turnover for accounts
receivable and inventories and reducing the days payable by approximately 10 percent per
year do not appear unreasonable. Depreciation and amortization expense represented only
2.7 percent of total operating expenses during Year 11, so cost of goods sold and selling and
administrative expenses are primarily variable costs. Thus, achieving the 49 percent
assumption for cost of goods sold to sales and the 41 percent assumption for selling and
administrative expense to sales seems reasonable.
5-26
Chapter 5
Risk Analysis
However, the cash flow ratios at the end of Year 11 and as projected for the end of Year
12 are not at healthy levels. The negative cash flow from operations projected for Year 12
is troublesome. Likewise, the cash flow ratios projected for the end of Year 13 after
repayment of the loan are not at healthy levels.
D.
Collateral: If cash flows are not adequate to service the loan, the bank has the right to sell
the collateral. There does not appear to be much collateral for the increased loan. The
companys machinery and equipment already serve as collateral for the existing loan. Most
of the capital expenditures the company intends to make with the loan proceeds are for
tooling and testing of the Soapstone Stove II stove. These expenditures will not likely result
in an asset the bank could easily repossess and sell to obtain funds to repay the loan. The
use of the loan proceeds for legal expenses may or may not result in an asset that could
serve as collateral. The inventory probably serves as collateral for accounts payable to
suppliers. This inventory is specific to the companys stoves and probably is not easily
salable. Given that the bank already requires the pledging of investments in common stock
of two of the shareholders and the personal guarantees of three of the shareholders, there is
not likely much additional collateral for the increased loan.
E.
Capacity for Debt: One approach to assessing debt capacity is to examine the proportion
of debt in the capital structure. Because of the accumulated deficit in retained earnings,
liabilities exceed total assets. However, all of the accumulated deficit relates to the garden
supply business. The company discontinued this business in Year 9. All of the long-term
debt relates to shareholder loans. The company has no current plans to repay this debt. If
we reclassify this long-term debt as part of shareholders equity, the liabilities to assets ratio
on December 31, Year 11, will be 76.1 percent. Besides this percentage being very high, all
of the liabilities are short-term. Another approach to assessing debt capacity is to examine
the companys ability to service the debt. The cash flow from operations to current
liabilities and to total liabilities ratios are below the 40 percent and 20 percent levels,
respectively, for a healthy company. The interest coverage ratios are very low. Although
these ratios improve by Year 13 when the loan is due, they are still not at particularly
healthy levels. Thus, the company does not appear to have much unused debt capacity.
One positive factor is that the company was able to reduce its bank borrowing during Year 5
from $125,256 to $93,091, a year when net income was $16,449. The company now wants
to increase its bank borrowing back to the $143,091 level, but it projects net income of
$24,052 in Year 12 and $122,807 in Year 13.
5-27
Chapter 5
Risk Analysis
F.
Contingencies: Two contingencies cloud the companys future. First, a favorable outcome
to the lawsuit is likely but uncertain. Legal expenses might exceed the $45,000 currently
forecasted. If the court finds in favor of the company, the company might have difficulty
finding tenants for the other 40 percent of the building. If it does, it may incur costs to alter
the space to suit the needs of the new tenants. On the other hand, the company will receive
cash at the time of settlement because the balance of the unpaid mortgage exceeds the option
price. It could use this cash to fund needed improvements to the building or pay carrying
costs until it finds new tenants. Also, the companys aggressive pursuit of the lawsuit
suggests that the market value of the building substantially exceeds the option price,
possibly providing collateral for both the mortgage assumed and the increased bank loan.
Finally, the company will secure low-interest financing upon assumption of the unpaid
mortgage.
The second contingency is the EPA approval status of the Soapstone Stove II stove.
Actual costs may exceed those expected, and the required time for approval may take longer
than expected. It does not appear that this stove will be approved and generating revenue
prior to the time the company must repay the increased bank loan.
G.
Character of Management: Character refers to both the integrity of management and its
ability to adapt successively to changing business conditions. Are the managers committed
to making a go of the firm? Do they possess the skills necessary to bring the firm through
difficult times? Do they have a vision of where the firm is going? The company appears to
score well on this factor. The company is one of the small number of survivors in the
industry. It has carved itself a market niche in the retail direct marketing segment. It has
had one of its stoves approved by the EPA and has another stove in the approval process.
The willingness to sustain significant legal expenses over a period of years suggests that the
option does have value and that the building is a part of the companys future strategy. The
willingness of the major shareholders to commit their personal wealth to the claims of
creditors suggests a commitment to the business and a need to make it successful.
H.
Communication: The case does not provide information on how well the company has
kept its bank informed about its past activities or its future plans.
5-28
Chapter 5
Risk Analysis
I.
Conditions: The case is silent on constraints the bank will place on the company beyond
the interest rate and the repayment date of the loan. The bank might specify a lid on the
amount of expenditures the company can make to obtain approval of the Soapstone II stove.
The bank would not want to impose constraints that impede operations, such as minimum
levels of net income and assets turnovers. It appears that the only way the company will be
able to repay the loan is if operations are profitable and the company generates cash flow.
Requiring additional collateral does not appear reasonable. Existing collateral does not
appear to be sufficiently liquid (except the common stock investments) to make
repossessing the collateral an attractive option if the company cannot service the loan. The
only potential bright spot with respect to collateral is that the building appears to have a
market value in excess of the unpaid loan. If the lawsuit is successful for the company, as
expected, additional collateral may be available to support the requested bank loan.
5-29
Chapter 5
Risk Analysis
Case 5.3: Fly-By-Night International Group: Can This Company Be Saved?

I.
Objectives
A.
Illustrate the impact on the financial statements of a continually changing corporate strategy.
II.
B.
Assess the likelihood of survival of a firm experiencing severe profitability and cash flow
problems.
C.
Address ethical questions about the dealings of a majority shareholder of a publicly held
corporation who also is CEO (chief executive officer) and chair of the board of directors.
Approach to Teaching the Case

A.
Begin by placing the segment data in Note 3 to the financial statements on an overhead
transparency. Ask students to describe the likely rationale for FBNs involvement in the
five businesses indicated by the segment data for Year 10. Each business is an integral part
of acquiring, using, and disposing of aircraft. Aircraft and related support operations require
investments of fixed capital. FBN can realize economies of scale by spreading the cost of
this fixed capital over business, transport, and training operations and the servicing of the
aircraft of other entities.
B.
Next, raise the question as to why FBN likely discontinued its Transport and Training
segments. These operations were not very profitable in Year 10. Each would require
managements attention to return the operations to profitability, yet they relate only
tangentially to FBNs main flight operations business. The customer base (businesses,
medically ill individuals, and former military pilots) is more widespread than flight
operations and requires a different kind of marketing effort than that required for
government contract work.
C.
Finally, ask why FBN likely sold its Aircraft Sales and Leasing segment. FBN derived a
substantial portion of its operating profit from this segment in Year 10 and Year 11. One
possible explanation is that FBN had only a limited advantage in competing effectively in
this segment. Its principal advantage was its knowledge of Learjets. FBN competed in this
segment with large financial institutions that provided financing to corporate customers to
purchase or lease aircraft. FBN had no advantage with respect to cost of capital that would
permit it to underprice these financial institutions. A second possible explanation for selling
the segment relates to the buyer. FBN sold this segment to a company owned by Douglas
Mather, CEO and majority shareholder of FBN. FBN sold additional aircraft in Year 14 to a
company owned by Douglas Mather. These transactions and others in the case raise
questions regarding the role and power of a CEO/majority shareholder in a publicly held
corporation. The law provides the minority shareholders with certain rights. The board of
directors is responsible for establishing control systems to ensure the protection of all
shareholders, including the minority owners. Given Douglas Mathers ownership
percentage and central role in organizing and running FBN, one wonders about the ability of
board members to be independent of Mather. The facts of the case suggest that board
members did not effectively assume their responsibilities in this regard until late Year 14.
We try to delay student discussion of the ethical issues until after addressing other issues in
the case.
5-30
Chapter 5
Risk Analysis
III.
Responses to Questions
a.
Signals of Cash Flow Problems
1. Significant increase in fixed assets (220 percent) and related debt (318 percent) in Year
13 followed by only a 50 percent increase in sales in Year 14 led to significant
diseconomies of scale. If we assume that the cost of services and selling and
administrative expenses are variable (some portion is likely to be fixed), the cost
structure and breakeven are as follows:
Year 10 Year 11
Sales ...............................
100.0% 100.0%
Variable Expenses ..........
(82.0)
(62.7)
Contribution Margin .......
18.0%
37.3%
Fixed Expenses:
Interest ......................... $ 2,600 $ 2,743
Depreciation ................
3,003
2,798
Breakeven Sales ............. $ 31,128 $ 14,885
Year 12 Year 13 Year 14

100.0% 100.0% 100.0%
(77.1)
(79.4) (80.1)
22.9%
20.6% 19.9%
$ 1,101 $ 3,058 $ 5,841
1,703
3,550
9,810
$ 12,245 $ 32,078 $ 78,648
The increase in sales in Year 14, although impressive, was not sufficient to provide
for profit and cash flow. It is not clear why FBN would purchase so many additional
aircraft. Perhaps the firm had an opportunity to purchase the fleet of a corporation that
was disposing of its aircraft and obtained an attractive price for the fleet. Perhaps FBN
anticipated new government contract work and wanted to gear up its capacity
accordingly.
2.
Excluding discontinued operations, the ROA, profit margin, assets turnover, and ROCE
indicate declining profitability between Year 12 and Year 14. The cost of services in
Year 12 and Year 13 increased faster than sales. Perhaps FBN hired the pilots for its
new aircraft in anticipation of new government contracts. The pilots may have had
fixed salaries for a portion of their compensation. Selling and administrative expenses
increased faster than sales in Year 12 and Year 14. Depreciation expense increased
faster than sales in all three years due to the addition of new aircraft.
5-31
Chapter 5
Risk Analysis
3.
Although cash flow from operations was substantial in Year 13 and Year 14, it occurred
largely because of stretching accounts payable and other current liabilities. There are
limits as to how much a firm can stretch these items to conserve cash.
4.
During Year 12 to Year 14, FBN assumed increasing amounts of variable rate debt to
purchase aircraft. It is unclear whether FBN could pass along any interest rate
increases on this debt to the government under its contracts. The fact that interest
expense as a percentage of sales increased during the last three years suggests that FBN
did not pass on any increasing interest cost.
5.
The transactions between Mather and FBN suggest a pattern whereby Mather shared
economic profits from various transactions between FBN and himself personally.
Several of these transactions occurred in Year 13 and Year 14. One wonders how
much potential cash flow (and profits) Mather redirected from FBN to himself during
this period. We get students to address the ethical issues by focusing on only one of the
issues described in the case. We usually address the sale of the Eastwind aircraft. We
have a student summarize the pertinent facts. On April 27, Year 14, FBN purchased
four Eastwind aircraft. Sometime between April 27, Year 14, and late September or
early October of Year 14, FBN sold these aircraft to Transreco, a corporation controlled
by Douglas Mather, for a profit of $1,600,000. Transreco subsequently sold these
aircraft to an unaffiliated third party for a profit of $780,000. Mather did not inform
other officers or directors about the transaction until late September, Year 14.
We begin by acknowledging that Mather should have obtained approval for the sale
from the board of Directors. We ask students to assume that he had obtained such
approval and then ask whether Mather did anything wrong if he obtained such
approval. Approximately half the students argue that Mather did nothing legally wrong
and therefore they do not have a problem with his ethics. He obtained the required
approval. He has a right to transact with his company as long as the price is fair. The
other half of the students will chime in that he controls the board of directors and there
is evidence that he profited from the transaction. Therefore, the price could not have
been fair. We then ask students to assume that Mather got an independent appraisal of
the value of the aircraft at the time of the sale and purchased the aircraft at this
appraised value. We ask the second half of the students if they now have a problem
with the ethics of the transaction. Some students are comfortable with the transaction.
Others still see a potential conflict of interest. We then take Mathers position by
stating the following: FBN purchased new aircraft anticipating government contract
work that did not fully materialize. These purchases were hurting FBNs profitability
and cash flows. Mather purchased the excess aircraft not needed in operations to help
FBN deal with an overcapacity problem. Although a few more students now accept the
ethics of the transaction, some still argue that any transaction between a firm and its
CEO has the appearance of unethical behavior, even if none is actually present, and
should be avoided. The purpose of this discussion is to get students to see the many
sides of an ethical dilemma and to determine where they draw the line. Some students
equate the satisfaction of legal constraints with ethical behavior. Others draw a line
that avoids any transaction that has the potential for a conflict of interest that misleads
others.
5-32
Chapter 5
Risk Analysis
b.
Can FBN Avoid Bankruptcy in Year 15?

Positive Factors:
1. The board is now aware of its poor cost and accounting controls.
2. The board has fired Mather.
3. The company has government contracts in place extending through Year 16 and Year
17.
4. The banks have not yet demanded payment of their notes, despite violation of loan
covenants.
5. The company has tax loss and investment credit carryforwards.
6. The company has aircraft that it can sell to repay debt.
7. The company has a reasonably clear strategic focus.
Negative Factors:
1. All assets are already collateralized. The company has zero unused debt capacity.
2. With defense cutbacks, banks may call the debt and force liquidation immediately.
3. Altmans Z-score (see Exhibit 5.A) suggests a high probability of bankruptcy, although
FBN is not an industrial firm (as appropriate for Altmans Z score).
4. It is not clear who is now managing FBN.
5. Risk ratios are at very low levels. There is very little margin for safety. Sales must
increase 43 percent in Year 15 just to break even.
5-33
Chapter 5
Risk Analysis
IV. Epilogue
FBN is actually Flight International Group Inc., a Georgia corporation. The dates in the case were
changed. (Year 14 is actually 1989.) A venture capital group acquired a 33 percent interest in
Flight International Group in April 1990 (Year 15 in the case) and had an option to acquire another
one-third interest. The firm sold its fixed base operations segment and concentrated entirely on
fighter pilot training and continuation of its contract with the Federal Reserve Bank System. The
firm lost its contract with the U.S. Navy in 1993. It filed for bankruptcy in February 1994 in a
prearranged deal in which creditors exchanged debt for a majority of the common stock. The firm
emerged from bankruptcy in December 1994. It expected to derive approximately 50 percent of its
revenues from military flight operation and 50 percent from aircraft maintenance. It added
military contracts for parachute training in 1995 and continued to survive until July 2002, when it
was acquired by another firm and taken private.
5-34
Chapter 5
Risk Analysis
Exhibit 5.A
Z-Score Analysis for FBN
(Case 5.3)
Net Wk Cap
Retained Earnings
EBIT
M.V.Eq.
Sales
Z 1.2
1.4
3.3 Assets .6 B.V.Liab. 1.0 Assets
Assets
Assets
Year 10
$6,963
$2,149
1.2
1.4
$39,061
$39,061
1.04 = .21
.08
$2,750
3.3
$39,061
.23
$6,500
.6
$33,281
$31,992
1.0
$39,061
.12
.82
Year 11
$1,083
$2,469
1.2
1.4
$17,924
$17,924
2.32 = .07
.19
$4,392
3.3
$17,924
.81
$6,000
.6
$11,112
$19,266
1.0
$17,924
.32
1.07
Year 12
$336
$3,208
1.2
1.4
$23,976
$23,976
1.71 = .02
.19
$3,044
3.3
$23,976
.42
$6,809
.6
$16,178
$20,758
1.0
$23,976
.25
.87
Year 13
$10,552
$3,802
1.2
1.4
$77,597
$77,597
$3,983
3.3
$77,597
.67 = .16
.07
.17
$13,893
.6
$68,287
.12
$36,597
1.0
$77,597
.47
Year 14
$66,810
$29
1.2
1.4
$102,243
$102,243
.02 = .78
$1,111
3.3
$102,243
.04
$31,896
.6
$85,921
$54,988
1.0
$102,243
.22
.54
5-35
Chapter 5
Risk Analysis
Case 5.4: Millennial Technologies: Apocalypse Now

I.
II.
Objectives
A.
Analyze the effect of various accounting irregularities on the financial statements.
B.
Assess the credit worthiness of a high-growth firm that has experienced lapses in its
financial controls.
C.
Apply bankruptcy prediction models and assess the likelihood of bankruptcy.
Responses to Case Questions

a. Year 5
Constant .................................................................................................
DSRI: .920[($3,932/$12,445)/($1,662/$8,213)] ...................................
GMI: .528[{($8,213 $4,523)/$8,213}/{($12,445 $6,833)/
$12,445}] .........................................................................................
AQI: .404[{1 (($15,443 + $1,323)/$18,199)}/{1 (($6,320 +
$669)/$7,590)}] ...............................................................................
SGI: .892($12,445/$8,213) ...................................................................
DEPI: .115[{$193/($193 + $669)}/{$337/($337 + $1,323)}] ..............
SAI: .172[($3,366/$12,445)/($1,889/$8,213)] ....................................
LVGI: .327[{($5,592 + $162)/$18,199}/{($1,132 + $0)/$7,590}] ....
TATA: 4.67[{$874 (5,665)}/$18,199] ............................................
Value of y ...............................................................................................
4.840
1.436
.526
.402
1.351
.127
.202
.693
1.569
.324
37.3%
Year 6
Constant ................................................................................................. 4.840
DSRI: .920[($12,592/$37,848)/($3,932/$12,445)] ...............................
.969
GMI: .528[{($12,445 $6,833)/$12,445}/{($37,848 $23,636)/
$37,848}] .........................................................................................
.634
AQI: .404[{1 (($48,191 + $4,698)/$55,782)}/{1 (($15,443 +
$1,323)/$18,199)}] ..........................................................................
.266
SGI: .892($37,848/$12,445) .................................................................
2.713
DEPI: .115[{$337/($337 + $1,323)}/{$645/($645 + $4,698)}] ...........
.193
SAI: .172[($4,591/$37,848)/($3,366/$12,445)] ..................................
.077
LVGI: .327[{($9,198 + $367)/$55,782}/{($5,592 + $162)/
$18,199}] .........................................................................................
.177
TATA: 4.67[{$4,902 (12,918)}/$55,782] .......................................
1.492
Value of y ...............................................................................................
1.173
87.9%
5-36
Chapter 5
Risk Analysis
b. Signals of Accounting Irregularities: Beneishs manipulation index shows a high probability of

manipulation for both fiscal Year 5 and Year 6. The rapid growth in sales and the extent of
accruals in earnings are major factors in this high probability. Large increases in accounts
receivable and inventories resulted in negative cash flow from operations each year. Perhaps
the most telling signal from the financial ratios but not in Beneishs manipulation index is the
relation between inventories and cost of goods sold. The high growth rate in sales means that
the analysts should interpret the inventory turnovers carefully. Use of average inventories in
the denominator of the inventory turnover ratio for a high-growth firm tends to increase the
rate of turnover. Even with this upward bias, the inventory turnover ratios for Millennial
Technologies seem unusually small. With products built to customer specifications and the
rapid pace of technological change, a turnover once every 200300 days seems too slow. The
inclusion of items in ending inventory that should have been included in cost of goods sold
decreases the numerator and increases the denominator of the inventory turnover ratio and
decreases the inventory turnover ratio. The negative cash flow from operations is not
unexpected for a rapidly growing firm that must invest in accounts receivable and inventories
to maintain its growth. The use of a line of credit to finance the receivables and inventories
also is not unusual. Finally, the use of equity instead of long-term debt financing is common
among high-growth technology companies. Such firms have few long-term assets that can
serve as collateral for such borrowing. Also, technological change results in short product life
cycles and high product obsolescence risk. Thus, the financial statements of Millennial
Technologies, with the exception of the inventory turnover ratio, reflect relationships that one
might expect for a high-growth technology-oriented firm.
c. Effect of Irregularities on the Financial Statements:
(1)
Invalid Sales Transactions: The invalid sales transactions overstate sales, cost of goods
sold, income tax expense, and net income on the income statement. In turn, the
transaction overstates accounts receivable for amounts not yet collected and understates
additional paid-in capital for amounts that have been collected that effectively represent
additional capital contributions by Mr. Pinoza. Cost of goods sold is overstated and
inventories are understated by the amount of the cost of the PC card housing. Cash flow
from operations is overstated and cash flow from financing is understated by the amount
collected from Mr. Pinoza. The balance in cash is correct. The financing section of the
restated statement of cash flows shows the amount collected each year from Mr. Pinoza.
(2)
Bill and Hold Transactions: The improper cutoff of sales at each year-end had the
effect of overstating sales, cost of goods sold, income tax expense, and net income in the
first year and understating their amounts in the second year. The net effect on the income
statement for the two years combined is zero. However, the firm continued to keep the
books open in subsequent years, so new errors were created. Thus, the adjustment made
during the nine months ending March 31, Year 7, corrected for the poor cutoff on June
30, Year 6. The balance sheet for each intervening period reports overstated accounts
receivable, understated inventories, overstated income tax payable, and overstated
retained earnings. The amount of cash flow from operations is correct for each year,
although net income and changes in accounts receivable, inventories, and other current
liabilities will change.
5-37
Chapter 5
Risk Analysis
(3)
Inventory Counts: The firm likely overstated its ending inventories each year in an
effort to reduce cost of goods sold and inflate net income. Thus, cost of goods sold is
understated, income tax expense is overstated, and net income is overstated. The
irregularity resulted in overstated inventories, income tax payable, and retained earnings
on the balance sheet. The amount of cash flow from operations is correct as reported,
although the amount of net income and the change in inventories reflect offsetting errors.
(4)
Product Obsolescence: The failure to write down inventories for product obsolescence
resulted in the same errors as the preceding ones for the inventory counts.
(5)
Capitalization of Costs in Property, Plant, and Equipment:

The improper
capitalization of various costs in property, plant, and equipment resulted initially in an
overstatement of these fixed assets on the balance sheet, an understatement of various
expenses on the income statement, an overstatement of income tax expense and income
tax payable, and an overstatement of retained earnings. As Millennial Technologies
depreciated these capitalized amounts in subsequent years, it overstated operating
expenses, understated income tax expense, and understated net income each year. At the
end of the depreciable lives of these fixed assets, the initial errors were corrected on a
cumulative basis. The amount of cash flow from operations each year is understated and
the amount of cash flow from investing activities is overstated each year in the amount
improperly capitalized during the year. The effect of subsequent years depreciation
decreases net income but increases the addback for depreciation; so the net effect on cash
flow from operations is zero.
(6)
Improper Classification of Prepaid License Fees: The classification of the advance as

a receivable instead of a prepaid cost to be amortized results in understated expenses,
overstated income tax expense, and overstated net income. This error will not correct
itself over time. Thus, assets and retained earnings on the balance sheet are continually
overstated (until the firm made the correction).
5-38
Chapter 5
Risk Analysis
(7)
Inadequate Provision of Uncollectibles on Advances to Investees: Bad debt expense

is understated and income tax expense and net income are overstated by the amount of
the estimated uncollectible accounts. Most firms include advances to investees in the
investment account on the balance sheet. Thus, assets and retained earnings are
overstated until the firm provides adequately for these bad debts.
(8)
FASB Statement No. 115 requires firms to report marketable equity securities at market
value and report increases and decreases in market values since acquisition in a separate
shareholders equity account.
(These market value changes are included in
comprehensive income.) However, this reporting standard applies only to marketable
equity securities. Millennial Technologies reports most of its investments at cost,
suggesting that it has no readily determinable market value. Firms that use the cost
method must write down their investments in securities when there has been a permanent
decline in market value. Millennial Technologies failure to write down its investments
had the same effect on the financial statements as its failure to adequately provide for
uncollectible accounts.
d. The decision to extend credit to Millennial Technologies must rest on two positive factors: (1)
the viability of its products with established customers and (2) the fact that the firm has
identified and dealt with the accounting irregularities that occurred. However, traditional
financial ratios do not present an attractive picture. Cash flow from operations continues to be
negative because of rapid growth. The firm may be unable to obtain capital from the equity
markets until it reestablishes its credibility. Thus, the firm will need a line of credit to sustain
its growth. The unpaid balance of $10,090,000 on notes payable on March 31, Year 7,
represents 78 percent of accounts receivable and inventories on that date, a relatively high
percentage. Substantially all of the firms assets are pledged as collateral for existing
borrowing. Thus, a lender will have to look to accounts receivable and inventories obtained in
the future to provide collateral for any new borrowing. The lender should require the firm to
establish effective controls over accounts receivable and inventories, to institute internal audits,
and to allow the bank to audit the records and controls of the firm periodically. Given the risk,
an interest rate higher than prime is appropriate. Lending covenants containing debt and
interest coverage ratio constraints also would seem appropriate.
5-39
Chapter 5
Risk Analysis
e. The calculation of Altmans Z-score is as follows:

$4,569
($53,630)
($42,271) $50,069
$28,263
Z 1.2
1.4
3.3
.6
1.0
$51,198
$51,198
$51,198 $22,644
$51,198
Z =
Z =
.1071
1.4665
2.7246
1.3267
.5520
2.2053
f. The Altman Z-score indicates a high probability of bankruptcy as of March 31, Year 7,
primarily because of poor current and accumulated profitability. The Z-scores for previous
years were overstated because of the accounting irregularities or were dominated by the high
market value of the common equity. This case illustrates the circularity of the Altman model.
Analysts would like to use such a model to decide whether to invest in a firm at current market
prices. However, if the reported accounting numbers mislead investors, the high market values
will dominate the Z-score and give incorrect signals about the likelihood of bankruptcy.
As with the assessment of credit risk, the assessment of bankruptcy risk comes down to a
trade-off between the positive business attributes and the weak financial attributes. If the firm
concentrates on getting its financial shop in order and allows technological development or
customer relationships to falter, it may face serious bankruptcy risk.
5-40

ISM Chapter 05

Diunggah oleh

Informasi Dokumen

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

ISM Chapter 05

Diunggah oleh

Hak Cipta:

Format Tersedia

Chapter 5

Interpreting the Alternative Decomposition of ROCE with Negative Financial Obligations.

Effect of Transactions on Debt Ratios.

Issue Long-Term Debt for Cash:

Redeem Short-Term Debt with Cash:

5.12 Calculating and Interpreting Risk Ratios.

5.14 Interpreting Risk Ratios.

Revenues to Cash Ratio ..........

Operating Cash Flow to Current Liabilities Ratio:

Liabilities to Assets Ratio:

Long-Term Debt to Long-Term Capital Ratio:

Operating Cash Flow to Total Liabilities Ratio:

Interest Coverage Ratio:

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Operating Cash Flow to Current Liabilities Ratio:

Liabilities to Assets Ratio:

Long-Term Debt to Long-Term Capital Ratio:

Operating Cash Flow to Total Liabilities Ratio:

Interest Coverage Ratio:

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

5.17 Computing and Interpreting Bankruptcy Prediction Ratios:

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Altmans Z-Score for Circuit City

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

5.18 Applying and Interpreting Bankruptcy Prediction Models.

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

Altmans Z-Score for Marvel Entertainment

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

5.19 Applying and Interpreting Bankruptcy Prediction Models.

Altmans Z-Score for Washington Post

Probability of Bankruptcy ......................................................................

Probability of Bankruptcy ......................................................................

b. Altmans Z-score model indicates an increasing probability of bankruptcy for Tribune

5.20 Applying and Interpreting the Earnings Manipulation Model.

5.21 Reformulating Financial Statements, Preparing an Alternative Decomposition of ROCE, and

Integrative Case 5.1: Starbucks

Probability of Bankruptcy ..........................................................................

Beneishs Earnings Manipulation Score

Case 5.2: Massachusetts Stove CompanyBank Lending Decision

Growth Rate in Sales

Case 5.3: Fly-By-Night International Group: Can This Company Be Saved?

Approach to Teaching the Case

Year 12 Year 13 Year 14

Can FBN Avoid Bankruptcy in Year 15?

Case 5.4: Millennial Technologies: Apocalypse Now

Apply bankruptcy prediction models and assess the likelihood of bankruptcy.

Responses to Case Questions

b. Signals of Accounting Irregularities: Beneishs manipulation index shows a high probability of

Capitalization of Costs in Property, Plant, and Equipment:

Improper Classification of Prepaid License Fees: The classification of the advance as

Inadequate Provision of Uncollectibles on Advances to Investees: Bad debt expense

e. The calculation of Altmans Z-score is as follows: