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Chapter 5
Risk Analysis
5-21
in whole or in part.
c. NOPAT: $236,238 × (1 – 44.55%) = 131,005
Net Financing Expense (after tax): ($36,416 – $6,697) × (1 – 44.55%) = $16,481
Operating Profit Margin: $131,005/$7,953,912 = 1.65%
expense because all interest expense was included in the first approach. The net-
ting 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% to
Integrative Case 5.1: Starbucks
a. Current Ratio: $4,200/$2,210 = 1.90
Days Accounts Payable:
365/($5,813 + $1,242 – $966)/[0.5($398 + $540)] = 28.1 days
Net Days Working Capital: 69.3 + 57.6 – 28.1 = 98.8 days
Chapter 5
Risk Analysis
5-22
in whole or in part.
Altman’s Z-Score
Working Capital/Assets: 1.2[($4,200 – $2,210)/$8,219] ........................... 0.291
Market Value Equity to Book Value of Liabilities:
0.6[(749.3 × $50.71)/$3,105] ............................................................ 7.343
b. Short-Term Liquidity Risk: Starbucks displays decreasing short-term liquidity
risk. Its current ratio has grown from 1.55 to 1.90, and the quick ratio also
increased, but not monotonically. Both ratios have trended upward during the
term liquidity risk.
Bankruptcy Risk: Altman’s Z-score model shows virtually no probability of
bankruptcy, and the Z-score has increased substantially. A large part of the in-
Case 5.2: Massachusetts Stove Company—Bank Lending Decision
I. Objectives
Chapter 5
Risk Analysis
5-23
in whole or in part.
II. Teaching Strategy
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 Massa-
chusetts Stove Company. This approach adds structure to the discussion and pro-
vides students with a framework to apply to other lending decisions. The factors
tivity of the financial statement amounts to changes in the assumptions made. Stu-
dents need not have studied the preparation of pro forma financial statements to
appreciate their richness as a tool of analysis.
III. Case Discussion
ching 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 paya-
ble. It appears that Massachusetts Stove Company has repaid bank borrowing
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 estab-
lished credit.
Chapter 5
Risk Analysis
5-24
in whole or in part.
cash to repay the bank loan without adversely affecting operations and capital
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 Year 12 Year 13
10% ............................................................. $ (1,306) $34,676
during Year 11, so cost of goods sold and selling and administrative expenses
are primarily variable costs. Thus, achieving the 49% assumption for cost of
goods sold to sales and the 41% assumption for selling and administrative ex-
pense to sales seems reasonable.
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 company’s machinery and equipment already serve
accounts payable to suppliers. This inventory is specific to the company’s
Chapter 5
Risk Analysis
5-25
in whole or in part.
stoves and probably is not easily salable. Given that the bank already requires
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
assessing debt capacity is to examine the company’s ability to service the
debt. The cash flow from operations to current liabilities and to total
liabilities ratios are below the 40% and 20% levels, respectively, for a
healthy company. The interest coverage ratios are very low. Although these
in Year 12 and $122,807 in Year 13.
F. Contingencies: Two contingencies cloud the company’s future. First, a
favorable outcome to the lawsuit is likely but uncertain. Legal expenses
building or pay carrying costs until it finds new tenants. Also, the company’s
aggressive pursuit of the lawsuit suggests that the market value of the
mortgage.
The second contingency is the EPA approval status of the Soapstone
Stove II stove. Actual costs may exceed those expected, and the required
Chapter 5
Risk Analysis
5-26
in whole or in part.
G. Character of Management: Character refers to both the integrity of man-
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 company’s future strategy. The willingness of the major
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.
I. Conditions: The case is silent on constraints the bank will place on the
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
support the requested bank loan.
Case 5.3: Fly-by-Night International Group: Can This Company Be Saved?
I. Objectives
corporate strategy.
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.
