CHAPTER 5

RISK ANALYSIS
Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases

5.5. Effect of Transactions on Debt Ratios.

a. The effect of the four transactions on each debt ratio is as follows:

(1) Issue Long-Term Debt for Cash:

Liabilities to Assets Ratio: increase
Liabilities to Shareholders’ Equity Ratio: increase
Long-Term Debt to Long-Term Capital Ratio: increase

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Long-Term Debt to Shareholders’ Equity Ratio: increase

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(2) Issue Short-Term Debt and Use the Cash Proceeds to Redeem Long-Term Debt:

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Liabilities to Assets Ratio: no net effect

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Liabilities to Shareholders’ Equity Ratio: no net effect
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Long-Term Debt to Long-Term Capital Ratio: decrease
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Long-Term Debt to Shareholders’ Equity Ratio: decrease

(3) Redeem Short-Term Debt with Cash:

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Liabilities to Assets Ratio: decrease

Liabilities to Shareholders’ Equity Ratio: decrease
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Long-Term Debt to Long-Term Capital Ratio: no net effect

Long-Term Debt to Shareholders’ Equity Ratio: no net effect

(4) Issue Long-Term Debt and Use the Cash Proceeds to Repurchase Common Stock:
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Liabilities to Assets Ratio: increase

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Liabilities to Shareholders’ Equity Ratio: increase

Long-Term Debt to Long-Term Capital Ratio: increase
Long-Term Debt to Shareholders’ Equity Ratio: increase
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b. The four debt ratios move in the same direction except for transactions that in whole or
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in part involve cash and short-term debt [Transactions (2) and (3)]. When the latter
occurs, the liabilities to assets ratio and the liabilities to shareholders’ equity ratios
move in the same direction and the long-term debt to long-term capital and long-term
debt to shareholders’ equity move in the same direction. Thus, these debt ratios are
highly correlated. To identify changes in short- versus long-term debt, the analyst
should use one of the two ratios with total liabilities in the numerator and one of the
two ratios with long-term debt in the numerator.

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 5.12. Calculating and Interpreting Risk Ratios.
a. Revenues to Cash Ratio: $2,998/.5($521 + $725) = 4.8
Days Revenues in Cash: 365/4.8 = 76 days
Current Ratio: $1,718/$1,149 = 1.5
Quick Ratio: ($725 + $579)/$1,149 = 1.1
Operating Cash Flow to Current Liabilities Ratio:
$358/.5($930 + $1,149) = 0.344
Days Accounts Receivable:
$2,998/.5($607 + $579) = 5.1; 365/5.1 = 72 days
Days Inventory:
$1,252/.5($169 + $195) = 6.9; 365/6.9 = 53 days
Days Accounts Payable:
($1,252 + $195 – $169)/.5($159 + $168) = 7.8; 365/7.8 = 47 days

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Net Days Working Capital: 72 + 53 – 47 = 78 days

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Liabilities to Assets Ratio: $1,601/$3,241 = 0.494

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Liabilities to Shareholders’ Equity Ratio: $1,601/$1,640 = 0.976

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Long-Term Debt Ratio to Long-Term Capital Ratio:

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$303/($303 + $1,640) = 0.156

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Long-Term Debt to Shareholders’ Equity Ratio: $303/$1,640 = 0.185
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Operating Cash Flow to Total Liabilities Ratio:
$358/$.5($1,758 + $1,601) = 0.213
Interest Coverage Ratio: ($196 + $32 + $64)/$32 = 9.1
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b. The changes in the short-term liquidity risk ratios present mixed signals. Hasbro has
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built up its balance in cash so that it has more days of revenue held in cash. This trend
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provides Hasbro with liquidity and reduces its short-term liquidity risk. The current
and quick ratios were steady during the three years and at healthy levels. Again, these
results suggest low short-term liquidity risk. The operating cash flow to current
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liabilities ratio declined, and by Year 4, it was less than the 40 percent found for
healthy companies. The decrease in this ratio is the result of declining cash flow from
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operations and increasing current liabilities. Net income increased each year so that the
declining cash flow from operations is the result of changes in non-cash revenues and
expenses and in operating working capital accounts. Exhibit 4.30 indicates that the
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addback for depreciation and amortization decreased during the three years.
Depreciation and amortization do not affect cash flows; the smaller addback simply
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offsets the smaller expense. Thus, changes in depreciation and amortization do not
explain the declining cash flow from operations. It appears that the explanation lies
primarily in a decrease in prepayments in Year 2 and a decrease in accounts payable
and other current liabilities in Year 4. The analyst would be concerned with the
decrease in current liabilities in Year 4 only if it signaled pressure from suppliers of
various goods and services to pay their amounts due. Even then, Hasbro has more than
sufficient cash and accounts receivable to cover all current liabilities. The net days of
working capital declined sharply between Year 2 and Year 3 as a result of reducing the
days accounts receivable and inventory being held, a positive sign in terms of reducing
short-term liquidity risk. This occurred in a year when sales increased. The net days of
working capital increased again in Year 4, a year in which sales decreased. It would

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 not appear that Hasbro is unduly risky in terms of short-term liquidity risk at the end of
Year 4. Its current and quick ratios are at healthy levels and its days inventory and
accounts payable have been steady for the past two years. The only troublesome aspect
is the declining operating cash flow to current liabilities ratio. This ratio is not at a
level of extreme concern in Year 4, but a continuation of this trend could become
troublesome.

c. Hasbro’s long-term solvency risk has decreased significantly during the three-year
period. Debt levels have declined as Hasbro has redeemed debt. (See Hasbro’s
statement of cash flow in Exhibit 4.30.) Its interest coverage ratio has increased from a
worrisome level in Year 2 to a very healthy level in Year 4. The latter occurred
because of a reduction in borrowing and an increase in net income. Its operating cash
flow to total liabilities ratio has been steady and above the 20 percent threshold for a
healthy company. The reduced debt offset the declining cash flow from operations to

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provide a relatively stable cash flow ratio. The level of long-term solvency risk at the

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end of Year 4 appears low.

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5.15. Computing and Interpreting Risk and Bankruptcy Prediction Ratios for a Firm That

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Declared Bankruptcy.
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a. (1) Current Ratio:
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2000: $3,205/$5,245 = .61
2001: $3,567/$6,403 = .56
2002: $3,902/$6,455 = .60
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2003: $4,550/$6,157 = .74

2004: $3,606/$5,941 = .61
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(2) Operating Cash Flow to Current Liabilities Ratio:

2001: $236/.5($5,245 + $6,403) = 0.041
2002: $225/.5($6,403 + $6,455) = 0.035
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2003: $142/.5($6,455 + $6,157) = 0.023

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2004: $(1,123)/.5($6,157 + $5,941) = (0.186)

(3) Liabilities to Assets Ratio:

2000: $16,354/$21,931 = 0.746
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2001: $19,581/$23,605 = 0.830

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2002: $23,563/$24,720 = 0.953

2003: $26,323/$25,939 = 1.015
2004: $27,320/$21,801 = 1.253

(4) Long-Term Debt to Long-Term Capital Ratio:

2000: $5,797/($5,797 + $5,577) = 0.510
2001: $7,781/($7,781 + $4,024) = 0.659
2002: $9,576/($9,576 + $1,157) = 0.892
2003: $11,040/($11,040 – $384) = 1.036
2004: $12,507/($12,507 – $5,519) = 1.790

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 (5) Operating Cash Flow to Total Liabilities Ratio:
2001: $236/.5($16,354 + $19,581) = 0.013
2002: $225/.5($19,581 + $23,563) = 0.010
2003: $142/.5($23,563 + $26,323) = 0.006
2004: $(1,123)/.5($26,323 + $27,320) = (0.042)

(6) Interest Coverage Ratio:

2000: $1,829/$380 = 4.8
2001 to 2004: The interest coverage ratio is negative and, therefore, is
not covered.

b. Altman’s Z-Score

2000
Working Capital/Assets: 1.2[($3,205 – $5,245)/$21,931].................... (.112)

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Retained Earnings/Assets: 1.4($4,176/$21,931)................................... .267

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EBIT/Assets: 3.3($1,829/$21,931) ....................................................... .275

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Mkt. Value Equity/Liabilities: .6[(123 x $50.185)/$16,354] ................ .226
Sales/Assets: 1.0($15,657/$21,931)...................................................... .714

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Z-Score ................................................................................................ 1.370
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Probability of Bankruptcy ...................................................................... 35.5%
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2001
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Working Capital/Assets: 1.2[($3,567 – $6,403)/$23,605].................... (.144)

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Retained Earnings/Assets: 1.4($2,930/$23,605)................................... .174

EBIT/Assets: 3.3($–1,365/$23,605) ..................................................... (.191)
Mkt. Value Equity/Liabilities: .6[(123 x $29.26)/$19,581] .................. .110
Sales/Assets: 1.0($13,879/$23,605)...................................................... .588
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Z-Score ................................................................................................ .537

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Probability of Bankruptcy ...................................................................... 67.8%

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2002
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Working Capital/Assets: 1.2[($3,902 – $6,455)/$24,720].................... (.124)

Retained Earnings/Assets: 1.4($1,639/$24,720)................................... .093
EBIT/Assets: 3.3($–1,337/$24,720) ..................................................... (.178)
Mkt. Value Equity/Liabilities: .6[(123.4 x $12.10)/$23,563] ............... .038
Sales/Assets: 1.0($13,866/$24,720)...................................................... .561
Z-Score ................................................................................................ .390

Probability of Bankruptcy ...................................................................... 72.9%

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 2003
Working Capital/Assets: 1.2[($4,550 – $6,157)/$25,939].................... (.074)
Retained Earnings/Assets: 1.4($844/$25,939)...................................... .046
EBIT/Assets: 3.3($–432/$25,939) ........................................................ (.055)
Mkt. Value Equity/Liabilities: .6[(123.5 x $11.81)/$26,323] ............... .033
Sales/Assets: 1.0($14,087/$25,939)...................................................... .543
Z-Score ................................................................................................ .493

Probability of Bankruptcy ...................................................................... 69.4%

2004
Working Capital/Assets: 1.2[($3,606 – $5,941)/$21,801].................... (.129)
Retained Earnings/Assets: 1.4($–4,373/$21,801)................................. (.281)
EBIT/Assets: 3.3($–3,168/$21,801) ..................................................... (.480)
Mkt. Value Equity/Liabilities: .6[(139.8 x $7.48)/$27,320] ................. .023

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Sales/Assets: 1.0($15,002/$21,801)...................................................... .688

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Z-Score ................................................................................................ (.179)

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Probability of Bankruptcy ...................................................................... 88.1%

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c. The risk ratios are at very week levels throughout the five years, and consistent with
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these ratio results, the Altman Z-score model shows a high probability of bankruptcy in
all years. One interesting insight is that even in 2000, when Delta Air Lines was
profitable and its deteriorating financial health had not yet ramped up, it showed weak
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risk ratios and a fairly high probability of bankruptcy. The working capital and asset
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turnover ratios in the Altman model did not show much deterioration over the five-year
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period. However, its declining profitability contributed to increasing operating cash

flow problems, lowered shareholders’ equity, and increased liabilities. The
deterioration in 2004 was particularly pronounced. In one sense, the Altman model
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shows why the probability of bankruptcy is so high for Delta Air Lines. On the other
hand, one might say that Delta Air Lines remained out of bankruptcy for longer than
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the Altman model would predict. Airlines are able to weather financial storms
somewhat longer than manufacturing firms because lenders can rely on the collateral
provided by airplanes and not force liquidation. In addition, continuing to offer flights
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is critical to keeping customers, even if the flights are operated at a net loss. However,
despite attempts at cost cutting through 2004, the airline filed for bankruptcy on
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September 14, 2005.

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 5.18 Applying and Interpreting Bankruptcy Prediction Models.
a. Altman’s Z-Score for Harvard Industries

Year 5
Working Capital/Assets: 1.2[($195,417 – $176,000)/$662,262].......... .035
Retained Earnings/Assets: 1.4(–$115,596/$662,262)........................... (.244)
EBIT/Assets: 3.3($40,258/$662,262) ................................................... .201
Mkt. Value Equity/Liabilities: .6[(6,995 x $100.50)/$624,817] ........... .675
Sales/Assets: 1.0($631,832/$662,262).................................................. .954
Z-Score ................................................................................................ 1.621

Probability of Bankruptcy ...................................................................... 26.7%

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Year 6
Working Capital/Assets: 1.2[($156,226 – $163,384)/$617,705].......... (.014)

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Retained Earnings/Assets: 1.4(–$184,308/$617,705)........................... (.418)
EBIT/Assets: 3.3(–$11,012/$617,705) ................................................. (.059)

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Mkt. Value Equity/Liabilities: .6[(7,014 x $85)/$648,934] .................. .551
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Sales/Assets: 1.0($824,835/$617,705).................................................. 1.335
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Z-Score ................................................................................................ 1.395

Probability of Bankruptcy ...................................................................... 34.6%

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Altman’s Z-Score for Marvel Entertainment

Year 5
Working Capital/Assets: 1.2[($490,600 – $318,100)/$1,226,310]....... .169
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Retained Earnings/Assets: 1.4($114,100/$1,226,310).......................... .130

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EBIT/Assets: 3.3($25,100/$1,226,310) ................................................ .068

Mkt. Value Equity/Liabilities: .6[(101,703 x $10.625)/$948,100] ....... .684
Sales/Assets: 1.0($828,900/$1,226,310)............................................... .676
Z-Score ................................................................................................ 1.727
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Probability of Bankruptcy ...................................................................... 23.4%

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Year 6
Working Capital/Assets: 1.2[($399,500 – $345,800)/$844,000].......... .076
Retained Earnings/Assets: 1.4(–$350,300/$844,000)........................... (.581)
EBIT/Assets: 3.3(–$370,200/$844,000) ............................................... (1.447)
Mkt. Value Equity/Liabilities: .6[(101,810 x $1.625)/$999,700] ......... .099
Sales/Assets: 1.0($745,400/$844,000).................................................. .883
Z-Score ................................................................................................ (.970)

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

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 b. The Z-scores for Harvard Industries were in the range indicating a high probability of
bankruptcy in both fiscal Year 5 and fiscal Year 6. The firm has negative retained
earnings, indicating a history of net losses. The negative retained earnings is a
principal factor accounting for the firm’s Z-score falling in the high probability of
bankruptcy range. The Z-score decreased significantly between Year 5 and Year 6.
The firm operated at a net loss in fiscal Year 6, after generating net earnings in the
preceding two years. The net loss in fiscal Year 6 reduced working capital and hurt the
short-term liquidity ratios. Sales declined between fiscal Year 5 and fiscal Year 6 and
hurt the asset turnover.

c. The Z-scores of Marvel Entertainment fall in the range indicating a high probability of
bankruptcy in both years. Weak profitability, high levels of liabilities to assets, and
slow asset turnovers explain the low Z-scores. The decline in the Z-scores between
fiscal Year 5 and fiscal Year 6 results from substantially reduced profitability. Sales

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declined between the two years, consistent with the effect of reduced youth readership

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and interest in trading cards.

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d. Application of the bankruptcy prediction model suggests that Marvel Entertainment is

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more likely to file for bankruptcy during fiscal Year 7. The Z-score of Marvel
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Entertainment is lower and its probability of bankruptcy is higher for fiscal Year 6 than
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the corresponding ratio for Harvard Industries. Three positive signals for Harvard
Industries include (1) a sales increase between fiscal Year 5 and fiscal Year 6, in
contrast to the sales decrease for Marvel Entertainment; (2) a higher assets turnover for
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Harvard Industries; and (3) a much higher market price per common share for Harvard
Industries, suggesting that the market perceives the firm’s problems as correctable or
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the market does not perceive the bankruptcy risk of the firm. In addition, the
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.
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