Financial Management Concepts Quiz

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Questions and Answers

Which types of expenses should be adjusted proportionately when analyzing financial statements?

Cost of sales and SG&A (correct)

Annual bonuses

Gains or losses

Interest and depreciation

What happens to a firm's credit risk as profitability increases?

Credit risk becomes irrelevant

Credit risk remains unchanged

Credit risk increases significantly

Credit risk decreases (correct)

Why was Home Depot's ROE negative in 2019?

Inadequate revenue growth

High interest expenses affecting net income

Due to excessive operational costs

A result of large levels of treasury stock (correct)

Which profitability measure is not impacted by a company's leverage or treasury stock activities?

Return on Net Operating Assets (RNOA) Signup and view all the answers

What do flow ratios in coverage analysis help assess?

Ability to generate cash for obligations Signup and view all the answers

What is one reason companies demand credit for operating activities?

To cover operating losses Signup and view all the answers

Which entity is NOT typically a supplier of credit in the credit market?

Consumer credit agencies Signup and view all the answers

What is a common use of long-term debt for companies?

To finance corporate acquisitions Signup and view all the answers

Which of the following best characterizes trade credit?

It often includes early payment discounts Signup and view all the answers

In what scenario does financing activity demand for credit typically arise?

When a bank loan or bond matures Signup and view all the answers

What factor influences a creditor's willingness to provide credit?

The company's existing and ongoing creditworthiness Signup and view all the answers

Which of the following is NOT a common use of credit by companies?

Issuing equity shares Signup and view all the answers

What type of credit demand is considered routine and low risk?

Financing seasonal inventory purchases Signup and view all the answers

What is a key consideration when assessing Loss Given Default (LGD)?

The economic life of the asset must exceed the loan term. Signup and view all the answers

Which type of covenant prevents the borrower from taking certain actions?

Negative covenants Signup and view all the answers

What aspect of financial statements do analysts particularly scrutinize?

The accuracy of reflecting financial health and performance. Signup and view all the answers

What is one common adjustment analysts make to financial statements?

Correct for the effects of a 53rd week in the fiscal year. Signup and view all the answers

Which measure is commonly included in financial covenants?

Debt-to-equity ratio Signup and view all the answers

Why is there a need for adjustments in GAAP financial statements?

To get a clearer understanding of the company’s true financial condition. Signup and view all the answers

What is the typical occurrence of a 53rd week in a retailer's fiscal year?

Every 4-5 years Signup and view all the answers

What is an example of an affirmative covenant?

Requiring the submission of regular financial reports. Signup and view all the answers

What does solvency measure in a company?

The ability to meet debt obligations Signup and view all the answers

What should be considered when calculating ratios for a company with negative equity?

Restated numbers for better comparability Signup and view all the answers

Which of the following best describes liquidity ratios?

Ratios dealing with assets anticipated to convert into cash within a year Signup and view all the answers

How does solvency vary among companies?

It varies by industry and relative stability of cash flows Signup and view all the answers

Which statement best characterizes an insolvent company?

It is at risk of bankruptcy and likely failed Signup and view all the answers

What does the first variable in Altman's Z-Score model primarily measure?

Liquidity Signup and view all the answers

What level of accuracy does Altman's Z-Score model achieve in predicting bankruptcy for the first year?

95% Signup and view all the answers

Which component reflects a company's levered status in Altman's Z-Score model?

Market Value of Equity Signup and view all the answers

If Home Depot's Z-Score is greater than 3.00, what does this indicate about the company?

Healthy financial status with low bankruptcy risk Signup and view all the answers

Which aspect does the fifth variable in the Z-Score equation capture?

Total asset efficiency Signup and view all the answers

What does the times interest earned ratio reflect?

The operating income available to pay interest expenses Signup and view all the answers

Why is the EBITDA coverage ratio considered to be more widely used than the times interest earned ratio?

It excludes the effects of depreciation and amortization, which do not require cash outflow Signup and view all the answers

How is the cash from operations to total debt ratio significant?

It indicates the ability to generate cash to cover debt payments as they come due Signup and view all the answers

What adjustment is commonly made by credit analysts during financial statement analysis?

Adding back non-cash items to analyze cash flow Signup and view all the answers

Which of the following is true about the relationship between EBITDA and the times interest earned ratio?

EBITDA is always higher than the times interest earned ratio Signup and view all the answers

What does free operating cash flow to total debt account for?

Excess operating cash flow after capital expenditures Signup and view all the answers

What does liquidity specifically refer to in a financial context?

The availability of cash a company has Signup and view all the answers

What is the main purpose of coverage ratios in financial analysis?

To measure a company's ability to meet its financial obligations Signup and view all the answers

Study Notes

Financial Statement Analysis & Valuation

This is a sixth edition textbook.
Authors are Peter D. Easton, Mary Lea McAnally, and Gregory A. Sommers.
A free access code to myBusinessCourse is included with new copies of the book.

Module 4: Credit Risk Analysis and Interpretation

The objective is to describe the demand for and supply of credit.
Companies demand credit for operating, investing, and financing activities.
Credit is supplied by trade creditors, banks, public debt investors, and private lenders.
Demand and supply affect the credit market.

Demand for Credit—Operating Activities

Operating credit demand can be routine and low-risk.
Examples include cyclical operating cash needs, like materials or labor, and advance seasonal purchases.
Operating credit demand can signal higher risk, especially when used to cover operating losses.

Demand for Credit—Investing Activities

Companies require significant cash for investing activities like property, plant, equipment (PPE) purchases, or acquisitions.
Investment needs vary in timing and amount.
Mature firms display predictable capital expenditure and credit demands.

Demand for Credit—Financing Activities

Financing activities occur less frequently than operating and investing activities.
Common situations include bank loans or bond maturities where companies lack the necessary funds.
Funds are also used to pay dividends or repurchase stock.

Supply of Credit—Trade Credit

Trade credit from suppliers is usually non-interest bearing.
Suppliers' terms specify early payment discounts, maximum credit limits, payment terms, and other restrictions.
Suppliers tailor terms to particular customer creditworthiness.

Supply of Credit—Bank Loans

Bank loans are structured to meet specific client needs.
Revolving credit lines allow fluctuating cash balances with floating interest rates.
Letters of credit guarantee payment between a company and its supplier, with the bank interposed.
Term loans provide a set loan amount with periodic payments; interest rates are fixed or floating.
Mortgages are term loans secured by collateral.

Supply of Credit—Other Forms of Financing

Nonbank private financing is used when bank financing isn't available.
Private lenders often provide expertise in the specific industry and structure loan repayments.
Lease financing is frequently used for PPE acquisition, evaluating the credit risk of the lessee and collateral.

Supply of Credit—Publicly Traded Debt

Commercial paper is an efficient way to raise funds, regulated by the SEC, even if not publicly traded.
Short-term borrowing (270 days or less) is exempt from SEC regulation.
Bonds and debentures are public borrowings for longer durations, regulated by the SEC.
Principal is repaid on a fixed term with semi-annual or annual interest.

Learning Objective 2: Explain the credit risk analysis process

Credit risk analysis quantifies potential credit losses to facilitate informed lending decisions.
Expected credit loss is the product of the chance of default and loss given default.
Many parties, including trade creditors, financial institutions, public debt market participants, and credit rating agencies, perform credit risk analysis.

Chance of Default

Quantifies the risk of loss from non-payment.
Repayment ability depends on future cash flow and profitability.
Involves evaluating the loan's nature and purpose, macroeconomic environment, industry conditions, performing financial analysis, and conducting prospective analysis.

Step 1: Evaluate Nature and Purpose of the Loan

Determining the loan's necessity and nature is crucial.
Possible loan uses include cyclical cash flow needs, major capital expenditures, funding temporary or ongoing operating losses, and reconfiguring capital structure.

Step 2: Assess Macroeconomics Environment and Industry Conditions

Industry competition, buyer and supplier bargaining power, threat of substitution, and threat of new entrants influence business costs and pricing.

Step 3: Analyze Financial Ratios

Financial ratios are key in credit risk analysis, but there is no single "best" set of ratios.
Profitability and coverage, liquidity, and solvency ratios are often analyzed.

Step 4: Perform Prospective Analysis

Creditors must forecast the borrower's cash flows to estimate repayment ability.
Companies need cash to repay maturing debts and meet ongoing debt service obligations.
Financial statements need to be projected to compute future ratios.

Loss Given Default (LGD)

LGD is the potential loss if the borrowing company defaults on its obligations (i.e. failure to pay or covenant violations).
Companies must repay senior claims first.
Lenders mitigate loss through credit limits, collateral, repayment terms, and covenants.

Loss Given Default Factors: Collateral

Collateral is pledged property for guarantee of repayment, often real estate.
Credit analysis should assess existing liens.
Bankruptcy laws protect ordinary trade creditors by allowing the recovery of goods shipped within 45 days.

Loss Given Default Factors: Repayment Terms

Repayment term is the time for debt repayment.
Early payment discounts often apply to trade creditors.
Lenders consider the economic life of the asset in relation to the loan term when assessing LGD.

Loss Given Default Factors: Covenants

Covenants are loan terms mandating specific actions, restricting certain activities, or imposing financial conditions on borrowers.
Examples include requirements to submit financial statements or prohibitions on mergers/investments.

Learning Objective 3: Compute and Interpret Credit Risk Measures

Compute and interpret credit risk measures.

Adjusting Financial Information

Analysts scrutinize current and prior financial statements to accurately reflect company performance.
GAAP statements may not precisely reflect true financial condition.
Adjustments are made to financial statements to improve accuracy.

Profitability Analysis

Profitability affects bankruptcy risk: More profitable firms are less likely to default.
Return on Equity (ROE) can be disaggregated to assess profitability, considering return on assets and financial leverage.

Profitability Analysis (Home Depot)

Home Depot's 2019 ROE is negatively impacted by negative stockholders' equity.
High ROE in 2017 and 2018 due to treasury stock reducing stockholders' equity.

Expanded Profitability Analysis

RNOA (Return on Net Operating Assets) aggregates operating activity returns and includes comprehensive profitability measurement, unaffected by the company's leverage or treasury stock.
RNOA calculation considers Net Operating Profit Margin and Net Operating Asset Turnover.

Coverage Analysis

Coverage analysis evaluates a company's ability to generate cash to cover principal and interest payments.
"Flow" ratios are based on cash flow and income statement data.
Examples include Times Interest Earned, EBITDA Coverage Ratio.

Times Interest Earned Ratio

This ratio reflects income available for interest expense.

EBITDA Coverage Ratio

Calculated as Earnings Before Interest and Tax (EBIT) + Depreciation & Amortization / Interest expense, gross.
EBITDA is a non-GAAP metric used more often than Times Interest Earned ratios because depreciation/amortization doesn't require cash outflow.

Income Coverage Ratios (Home Depot)

A comparison of times interest earned versus EBITDA coverage for Home Depot across years to illustrate ratios' trends.

Coverage Analysis (Cash Flow)

Cash from operations to total debt evaluates the ability to generate cash for debt payments.
Free operating cash flow to total debt considers excess operating cash after capital expenditure.

Cash Flow Coverage Ratios (Home Depot)

Graph showing Home Depot's cash flow coverage across years.

Liquidity Ratios

Liquidity relates to cash availability and its short-term generation.
Current Ratio and Quick Ratio demonstrate cash availability and its conversion into cash.

Liquidity Ratios (Home Depot)

Data showing Home Depot's Current Ratio and Quick Ratio across years using graphs.

Solvency Ratios

Solvency assesses a company's ability to meet its debt obligations.
Insolvency signifies company failure.
Two common solvency ratios are the Liabilities-to-equity ratio and the total debt-to-equity ratio.

Solvency Analysis

Solvency varies by industry and depends on the relative stability of cash flows.
Exhibit 4.4 illustrates median ratios of liabilities-to-equity across different industries.

Solvency Analysis (Home Depot)

Home Depot's negative equity affects solvency ratio calculation, requiring stated numbers for comparison.
Graphs show Home Depot's liabilities-to-equity and debt-to-equity ratios over time

Learning Objective 5: Apply Bankruptcy Prediction Models to Evaluate Bankruptcy Risk

Assess a company's bankruptcy risk.
Altman's Z model predicts bankruptcy risk.

Bankruptcy Prediction Indicators (Altman's Z model)

Altman's Z model uses several variables to compute a Z-score relating to various factors indicative of financial health.

Z-Score Interpretation

Z-score is a measure of liquidity, long-term and short-term profitability, levered status, and total asset efficiency.
Scores above 3 represent low bankruptcy risk; scores below 1.8, high bankruptcy risk.

Application of Z-Score (Home Depot)

Home Depot's Z-score (2019) indicates low bankruptcy risk in the short-term.

Analyst Adjustments 4.1 & 4.2

Financial statements are adjusted or reformulated before ratio analysis.
These adjustments account for items such as defined benefit pension plans or multiemployer pension plans, operating leases (off-balance-sheet), or leases (on-balance-sheet).

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Description

Test your understanding of key financial management topics, including profitability measures, credit risk, and the implications of leveraging debt. This quiz covers various aspects of financial statements and credit market dynamics, essential for both students and professionals in finance.