Vol. 3 LM4 Credit Analysis & Geographic Segments

Question 1

Concept

is the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment

p. 235

Answer 1

credit risk

Question 2

Concept

is the evaluation of credit risk

p. 235

Answer 2

credit analysis

Question 3

Concept

a statistical analysis of the determinants of credit default

p. 235

Answer 3

credit scoring

Question 4

Concept

can be either long-term or short-term and is an indication of the rating angency’s opinion of the creditworthiness of a debt issuer with respect to a specific debt security

Answer 4

credit rating

Question 5

Concept

involves both the analysis of a company’s financial reports as well as a broad assessment of a company’s operations

p. 236

Answer 5

credit rating process

Question 6

Describe

(industry level) qualitative factors of a corporate credit rating

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Answer 6

industry level
* growth prospects
* volatility
* technological change
* competitive environment

Question 7

Describe

(company level) qualitative factors of a corporate credit rating

p. 236

Answer 7

company level
* operational effectiveness,
* strategy
* governance
* financial policies
* risk management practices
* risk tolerance

Question 8

Describe

quantitative factors of a corporate credit rating

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Answer 8

generally include:
* profitability
* leverage
* cash flow adequacy
* liquidity

Question 9

Calculate

EBITDA interest coverage

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Answer 9

numerator EBITDA^b
denominator interest expense, including non-cash interest on conventional debt instruments

^b EBITDA = EBIT, depreciation, and amortization

Question 10

Calculate

FFO^c (funds from operations) to debt

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Answer 10

numerator FFO
denominator total debt

^c EBITDA - net interest expense - tax expense

Question 11

Calculate

Free operating cash flow to debt

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Answer 11

numerator CFO^d (adjusted) minus capital expenditures
denominator total debt
^d CFO = cash flow from operations

Question 12

Calculate

EBIT margin

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Answer 12

numerator EBIT
denominator total revenues

Question 13

Calculate

EBITDA margin

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Answer 13

numerator EBITDA
denominator total revenues

Question 14

Calculate

debt to EBITDA

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Answer 14

numerator total debt
denominator EBITDA

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Question 15

Calculate

return on capital

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Answer 15

numerator EBIT
denominator Average beginning-of-year and end-of-year capital

Question 16

Calculate

Altman’s Z-score to predict financial distress

p. 237

Answer 16

Z = 1.2 x (Current assets - current liabilities)/Total assets +
* 1.4 x (Retained earnings/Total assets)
* + 3.3 x (EBIT/Total assets)
* + 0.6 x (Market value of stock/Book value of liabilities)
* + 1.0 x (Sales/Total assets)

Question 17

Define

operating segment

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Answer 17

1. that engages in activities that may generate revenue and create expenses, including a start up segment that has yet to earn revenues
2. who results are regularly reviewed by senior management
3. for which discrete financial information is avialable

Question 18

List

a company must disclose separate information about any operation segment under which conditions

p. 238

Answer 18

1. the segment constitutes 10 percent or more of the combined operation segments’ revenue, assets, or profit
2. the criteria is expressed in terms of the absolute value of the segment’s profit or loss as a percentage of the greater
   a. the combined profits of all profitable segments and
   b. the absolute amount of the combined losses of all loss-making segments

Question 19

List disclosures

each reportable segment

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Answer 19

• a measure of profit or loss;
• a measure of total assets and liabilities
• segment revenue, distinguishing between revenue to external customers and revenue from other segments
• interest revenue and interest expense;
• cost of property, plant, and equipment, and intangible assets acquired;
• depreciation and amortisation expense;
• other non-cash expenses;
• income tax expense or income; and
• share of the net profit or loss of an investment accounted for under the equity method

Question 20

List

segment ratios

p. 239

Answer 20

• segment margin
• segment turnover
• segment ROA
• segment debt ratio

Question 21

Concept

also known as “what if” analysis, which shows the range of possible outcomes as specific assumptions are changed; this could, in turn, influence financing needs or investment in fixed assets

p. 242

Answer 21

sensitivity analysis

Question 22

Concept

This type of analysis shows the changes in key financial quantities that result from given (economic) events, such as the loss of customers, the loss of a supply source, or a catastrophic event

p. 242

Answer 22

scenario analysis

Question 23

Concept

This is computer-generated sensitivity or scenario analysis based on probability models for the factors that drive outcomes

p. 242

Answer 23

simulation

Question 24

P1

Comparison of a company’s financial results to other peer companies for the same time period is called:

A. technical analysis.
B. time-series analysis.
C. cross-sectional analysis.

Practice Problems

p. 245

Answer 24

C. cross-sectional analysis

Question 25

P2

An analyst observes a decrease in a company’s inventory turnover. Which of the following would most likely explain this trend?

A. The company installed a new inventory management system, allowing more efficient inventory management.
B. Due to problems with obsolescent inventory last year, the company wrote off a large amount of its inventory at the beginning of the period.
C. The company installed a new inventory management system but experienced some operational difficulties resulting in duplicate orders being placed with suppliers.

Practice Problems

p. 245

Answer 25

C.
The company’s problems with its inventory management system
causing duplicate orders would likely result in a higher amount of inventory and would, therefore, result in a decrease in inventory turnover.
A more efficient inventory management system and a write off of inventory at the beginning of the period would both likely decrease the average inventory for the period (the
denominator of the inventory turnover ratio), thus increasing the ratio rather than decreasing it.

Question 26

P3

Which of the following would best explain an increase in receivables turnover?

A. The company adopted new credit policies last year and began offering credit to customers with weak credit histories.
B. Due to problems with an error in its old credit scoring system, the company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivables.
C. To match the terms offered by its closest competitor, the company adopted new payment terms now requiring net payment within 30 days rather than 15 days, which had been its previous requirement.

Practice Problems

p. 245

Answer 26

B.
A write off of receivables would decrease the average amount of
accounts receivable (the denominator of the receivables turnover ratio), thus increasing this ratio. Customers with weaker credit are more likely to make payments more slowly or to pose collection difficulties, which would likely increase the average amount of accounts receivable and thus decrease receivables turnover. Longer payment terms would likely increase the average amount of accounts receivable and thus decrease receivables turnover.

Question 27

P4

Brown Corporation had average days of sales outstanding of 19 days in the most recent fiscal year. Brown wants to improve its credit policies and collection practices and decrease its collection period in the next fiscal year to match the
industry average of 15 days. Credit sales in the most recent fiscal year were $300 million, and Brown expects credit sales to increase to $390 million in the next fiscal year. To achieve Brown’s goal of decreasing the collection period, the change
in the average accounts receivable balance that must occur is closest to:

A. +$0.41 million.
B. –$0.41 million.
C. –$1.22 million.

Practice Problems

p. 245

Answer 27

A.
Turnover equals 365 divided by DSO.
Turnover is 19.21 (= 365/19) for the most recent fiscal year and is targeted to be 24.33 (= 365/15) for the next fiscal year. The average accounts receivable balances are $15.62 million (= $300,000,000/19.21), and $16.03 million (=
$390,000,000/24.33). The change is an increase in receivables of $0.41 million

Question 28

P6

In order to assess a company’s ability to fulfill its long-term obligations, an analyst would most likely examine:

A. activity ratios.
B. liquidity ratios.
C. solvency ratios.

Practice Problem

p. 245

Answer 28

C.

Question 29

P10

Which ratio would a company most likely use to measure its ability to meet short-term obligations?

A. Current ratio.
B. Payables turnover.
C. Gross profit margin.

Practice Problems

p. 247

Answer 29

A.

Question 30

P11

Which of the following ratios would be most useful in determining a company’s ability to cover its lease and interest payments?

A. ROA.
B. Total asset turnover.
C. Fixed charge coverage.

Practice Problems

p. 247

Answer 30

C.
The fixed charge coverage ratio is a coverage ratio that relates known fixed charges or obligations to a measure of operating profit or cash flow generated by the company. Coverage ratios, a category of solvency ratios, measure the ability of a company to cover its payments related to debt and leases.

Question 31

Assuming no changes in other variables, which of the following would decrease ROA?

A. A decrease in the effective tax rate.
B. A decrease in interest expense.
C. An increase in average assets.

Practice Problems

p. 247

Answer 31

C.
Assuming no changes in other variables, an increase in average assets (an increase in the denominator) would decrease ROA. A decrease in either the effective tax rate or interest expense, assuming no changes in other variables, would increase ROA.

Question 32

P20

What does the P/E ratio measure?

A. The “multiple” that the stock market places on a company’s EPS.
B. The relationship between dividends and market prices.
C. The earnings for one common share of stock.

Practice Problems

p. 250

Answer 32

A.
The P/E ratio measures the “multiple” that the stock market places on a company’s EPS.

Question 33

P21

A creditor most likely would consider a decrease in which of the following ratios to be positive news?

A. Interest coverage (times interest earned).
B. Debt-to-total assets.
C. Return on assets.

Practice Problems

p. 251

Answer 33

B.
In general, a creditor would consider a decrease in debt to total
assets as positive news. A higher level of debt in a company’s capital structure increases the risk of default and will, in general, result in higher borrowing costs for the company to compensate lenders for assuming greater credit risk. A decrease in either interest coverage or return on assets is likely to be considered negative news.