1．The ratios below pertain to four firms being evaluated for credit risk.

Which of these firms demonstrates the greatest capacity to pay principal and interest?

A)   Firm A.

B)   Firm D.

C)   Firm C.

D)   Firm B.

2．The ratios below pertain to four firms being evaluated for credit risk.

Which of these firms demonstrates the greatest capacity to pay principal and interest?

A)   Firm A.

B)   Firm C.

C)   Firm D.

D)   Firm B.

3．Which of the following would indicate a lessened capacity by a corporate bond issuer to pay principal and interest? Relative to the industry average, the issuer’s:

A)   acid-test ratio is lower.

B)   equity is higher relative to its long-term debt.

C)   interest expense is lower relative to earnings.

D)   current liabilities are lower relative to current assets.

1．The ratios below pertain to four firms being evaluated for credit risk.

Which of these firms demonstrates the greatest capacity to pay principal and interest?

A)   Firm A.

B)   Firm D.

C)   Firm C.

D)   Firm B.

The correct answer was  C)

Firm C demonstrates the greatest capacity to pay. Firm C has the highest acid-test ratio, highest interest coverage ratio, and lowest capitalization (debt) ratio. The acid-test ratio is the current assets minus inventory divided by the firm’s current liabilities. A higher acid-test ratio indicates greater capacity to pay principal and interest. The interest coverage ratio is typically computed as earnings before interest and taxes (EBIT) divided by annual interest expense. A higher interest coverage ratio indicates greater capacity to pay principal and interest. Lower levels of debt (i.e. lower capitalization ratios) also indicate greater capacity to pay.

2．The ratios below pertain to four firms being evaluated for credit risk.

Which of these firms demonstrates the greatest capacity to pay principal and interest?

A)   Firm A.

B)   Firm C.

C)   Firm D.

D)   Firm B.

The correct answer was  C)

Firm D demonstrates the greatest capacity to pay. Firm D has the highest net profit margin, highest current ratio, and lowest financial leverage (debt) ratio. Higher net profits, lower debt, and higher current assets relative to current liabilities (a higher current ratio) indicate greater capacity to pay.

3．Which of the following would indicate a lessened capacity by a corporate bond issuer to pay principal and interest? Relative to the industry average, the issuer’s:

A)   acid-test ratio is lower.

B)   equity is higher relative to its long-term debt.

C)   interest expense is lower relative to earnings.

D)   current liabilities are lower relative to current assets.

The correct answer was  A)

The acid-test ratio is the current assets minus inventory divided by the firm’s current liabilities. A lower acid-test ratio would indicate lessened capacity to pay principal and interest. In essence, there is less assets to cover the firm’s current obligations. Higher equity relative to debt indicates greater capacity to pay. Lower interest expense indicates greater capacity to pay. Lower current liabilities relative to current assets indicates greater capacity to pay.