978-1337614689 Chapter 5 Part 2

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Risk Analysis

5-16

with Best Buy’s 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 firm’s net income was negative in both years

remains in the low probability of bankruptcy area.

d. The Z-scores did not predict that Circuit City or Best Buy would file for

5.20 Applying and Interpreting Bankruptcy Prediction Models.

a. Altman’s Z-Score for ABC Auto

Year 5

Year 6

Working Capital/Assets: 1.2[($156,226 – $163,384)/$617,705] ……….. (0.014)

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Altman’s Z-Score for XYZ Comics

Year 5

Working Capital/Assets: 1.2[($490,600 – $318,100)/$1,226,310] …….. 0.169

Year 6

Working Capital/Assets: 1.2[($399,500 – $345,800)/$844,000] ……….. 0.076

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

b. The Z-scores for ABC Auto were in the range indicating a high probability of

c. The Z-scores of XYZ Comics fall in the range indicating a high probability of

reduced youth readership and interest in trading cards.

d. Application of the bankruptcy prediction model suggests that XYZ Comics is

more likely to file for bankruptcy during fiscal Year 7. The Z-score of XYZ

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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.

5.21 Applying and Interpreting Bankruptcy Prediction Models.

a. Altman’s Z-Score for The Tribune Company

2006

2007

Altman’s Z-Score for The Washington Post Company

2006

2007

Working Capital/Assets: 1.2[($995 – $1,013)/$6,005] …………………….. (0.004)

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b. Altman’s Z-score model indicates an increasing probability of bankruptcy for

c. Altman’s Z-score model indicates a low probability of bankruptcy for The Wash-

d. Altman’s bankruptcy prediction model suggested that there was a high probabil-

ity that The Tribune Company would file for bankruptcy in 2008. There was

5.22 Reformulating Financial Statements, Preparing an Alternative Decomposition

of ROCE, and Assessing Financial Flexibility.

a. ROE = MARGIN × TURNOVER × LEVERAGE

b. Effective Tax Rate: $91,995/$206,519 = 44.55%

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c. NOPAT: $236,238 × (1 – 44.55%) = 131,005

Net Financing Expense (after tax): ($36,416 – $6,697) × (1 – 44.55%) = $16,481

d. The inferences under either treatment are that the company has a relatively low

Operating ROA, modest Leverage, and small Spread. The second approach re-

Integrative Case 5.1: Walmart

a. Current Ratio: $60,239/$64,619 = 0.93

Quick Ratio: ($8,705 + $5,624)/$64,619 = 0.22

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Altman’s Z-Score

Working Capital/Assets: 1.2[($60,239 – $64,619)/$199,581] ………………. (0.0263)

b. Short-Term Liquidity Risk: Walmart shows limited persistent changes in its

short-term liquidity. Its current ratio grew from 0.88 in 2013 to 0.97 in 2014, then

back to 0.90 in 2015. The quick ratio shows a similar pattern from 0.20 to 0.22.

Long-Term Solvency Risk: Walmart’s total liabilities and liabilities ratios have

Bankruptcy Risk: Altman’s Z-score model shows virtually no probability of

Case 5.2: Massachusetts Stove Company—Bank Lending Decision

I. Objectives

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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

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% projected

growth in sales, to repay suppliers, and to provide funds for expected nonre-

B. Credit: The firm has an ongoing relationship with its bank, having reduced

C. Cash Flows: The bank prefers that the company generate sufficient cash flows

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cash to repay the bank loan without adversely affecting operations and capital

expenditures. Students should question the assumed growth rate in sales of

25% 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 Year 12 Year 13

Regardless of the growth rate in sales, it appears that the firm will have suffi-

cient cash to repay the bank loan.

The company has reduced its days accounts receivable, inventory, and ac-

counts payable during the last three years. Thus, maintaining the current rates

of turnover for accounts receivable and inventories and reducing the days pay-

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

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stoves and probably is not easily salable. Given that the bank already requires

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

F. Contingencies: Two contingencies cloud the company’s 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% of the building. If it does, it may incur costs to alter the space to suit the

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G. Character of Management: Character refers to both the integrity of man-

agement and its ability to adapt successfully to changing business conditions.

Are the managers committed to making a go of the firm? Do they possess the

H. Communication: The case does not provide information on how well the

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

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

I. Objectives

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II. 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

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.

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

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III. Responses to Questions

A. Signals of Cash Flow Problems

1. Significant increase in fixed assets (220%) and related debt (318%) in

Year 10 Year 11 Year 12 Year 13 Year 14

Sales …………………………. 100.0% 100.0% 100.0% 100.0% 100.0%

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

2. Excluding discontinued operations, the ROA, profit margin, assets

turnover, and ROCE indicate declining profitability between Year 12 and

3. Although cash flow from operations was substantial in Year 13 and Year

4. During Year 12 to Year 14, FBN assumed increasing amounts of varia-

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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

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

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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.

Negative Factors:

1. All assets are already collateralized. The company has zero unused debt

capacity.

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

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Risk Analysis

Exhibit 5.A

Z-Score Analysis for FBN

(Case 5.3)

Year 10

Year 11

Year 12

Year 13

Year 14