Chapter 10 Chapter 10
Credit Analysis and Distress Prediction
Discussion Questions
1. Financial analysts typically measure financial leverage as the ratio of debt to equity. However, there is
less agreement on how to measure debt, or even equity. How would you treat the following items in
computing this ratio? Justify your answers.
• Revolving credit agreement with bank
Revolving credit agreement with bank allows the company to borrow up to a certain amount (line
Cash and marketable securities can be considered as negative leverages. Having high cash and
Operating leases can be used to finance the right to use an asset for a fixed period. The question of
whether this is effectively debt and should be included in debt ratios depends on the nature of the
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Unrecorded pension commitments are effective debt commitments. The firm has agreed to fund
Deferred tax liabilities represent the increase in taxes payable in future years as a result of taxable
Preferred stock may be treated as equity. Despite the fact that preferred stock offers a fixed
Convertible debt gives its owner the option to exchange the bond for a predetermined number of
2. U.S. public companies with “low” leverage have an interest-bearing net debt-to-equity ratio of 0 percent
or less, firms with “medium” leverage have a ratio between 1 and 62 percent, and “high” leverage firms
have a ratio of 63 percent or more. Given these data, how would you classify the following firms in terms
of their optimal debt-to-equity ratio (high, medium, or low)?
Successful pharmaceutical company. Low debt-to–equity ratio. A pharmaceutical company’s
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Start-up software company. Low debt-to-equity ratio. A start-up software company’s business
3. What are the critical performance dimensions for (a) a retailer and (b) a financial services company
that should be considered in credit analysis? What ratios would you suggest looking at for each of these
dimensions?
The critical performance dimensions of a retailer are related to its inventory turnover and profit
4. Why would a company pay to have its public debt rated by a major rating agency (such as Moody’s or
Standard and Poor’s)? Why might a firm decide not to have its debt rated?
The public debt rating influences the yield that must be offered to sell the debt instrument. Suppose
that a company has information that is favorable in borrowing but confidential. It would disclose the
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and shareholders will question corporate managers’ performance in cases of downgrades.
5. Some have argued that the market for original-issue junk bonds developed in the late 1970s as a result
of a failure in the rating process. Proponents of this argument suggest that rating agencies rated
companies too harshly at the low end of the rating scale, denying investment grade status to some
deserving companies. What are proponents of this argument effectively assuming were the incentives of
rating agencies? What economic forces could give rise to this incentive?
Proponents of this argument are assuming that rating agencies are more likely to be conservative,
because the cost of incorrect rating is asymmetrically severe if the investment-grade firms go
6. Many debt agreements require borrowers to obtain the permission of the lender before undertaking a
major acquisition or asset sale. Why would the lender want to include this type of restriction?
When the firm is in financial difficulty, conflicts may arise between debtors and stockholders.
Managers who are likely to represent stockholders’ interest may invest in riskier assets. Since the
7. Betty Li, the CFO of a company applying for a new loan, states, “I will never agree to a debt covenant
that restricts my ability to pay dividends to my shareholders because it reduces shareholder wealth.” Do
you agree with this argument?
Betty argues that restricting the flexibility of management decisions (such as dividend payout
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8. Cambridge Construction Company follows the percentage-of-completion method for reporting long-
term contract revenues. The percentage of completion is based on the cost of materials shipped to the
project site as a percentage of total expected material costs. Cambridge’s major debt agreement includes
restrictions on net worth, interest coverage, and minimum working capital requirements. A leading
analyst claims that “the company is buying its way out of these covenants by spending cash and buying
materials, even when they are not needed.” Explain how this might be possible.
Under the revenue recognition method of Cambridge Construction Company, the company can
accelerate revenue (and net income) recognition by purchasing materials. Suppose that the company
9. Can Cambridge improve its Z-score by behaving as the analyst claims in Question 8? Is this change
consistent with economic reality?
Cambridge can improve its Z-score by accelerating revenue recognition even if this change is not
consistent with economic reality. Accounting choice in Question 8 positively influences all of the
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10. A banker asserts, “I avoid lending to companies with negative cash from operations because they are
too risky.” Is this a sensible lending policy?
No. A banker should decide whether the borrowing firm has the ability to service the debt at the
scheduled rate. Current period negative cash flow from operations is one of the factors that the
11. A leading retailer finds itself in a financial bind. It doesn’t have sufficient cash flow from operations
to finance its growth, and it is close to violating the maximum debt-to-assets ratio allowed by its covenants.
The Vice-President for Marketing suggests, “We can raise cash for our growth by selling the existing
stores and leasing them back. This source of financing is cheap, since it avoids violating either the debt–
to–assets or interest coverage ratios in our covenants.” Do you agree with his analysis? Why or why not?
As the firm’s banker, how would you view this arrangement?
No, for several reasons. First, depending on the terms of the lease, accounting rules may ensure that