Problem Set 19

Sweet Peas' loss in 2018 signals a structural weakness in profitability that willlikely persist across future years

FALSE

Sweet Peas' loss was temporary and tied to the opening of a new store, not a structural decline in its business model. The company maintained stable asset turnover and strong liquidity ratios, and management cut dividends to preserve cash. This pattern suggests a temporary bad year driven by investment timing rather than enduring profitability weakness.

A revolving line of credit should normally be used to finance long-term fixed-assetpurchases when the interest rate is favourable

FALSE

A revolving line of credit should not be used for long-term fixed-asset purchases, even if the rate looks attractive. Doing so converts a short-term facility into permanent financing, masking the firm's true leverage. It also defeats the self-liquidating purpose of a working-capital line and exposes both borrower and bank to maturity-mismatch risk.

A firm's inability to pay down its line of credit for 30 consecutive days indicatesthat the loan is functioning more like permanent capital than seasonal working capital

TRUE

When a borrower cannot reduce its credit line balance to zero for at least 30days, it signals the facility is functioning like term debt. This pattern means the firm is funding ongoing operations or fixed assets with short-term money. From a banker's perspective, it violates the self-liquidating loan principle and raises long-term repayment-capacity concerns.

Inland Lakes' decision to raise dividends despite declining margins suggests a management team prioritizing shareholder payouts over financial resilience

TRUE

Inland Lakes' decision to raise dividends despite eroding margins shows management prioritizing shareholder payouts over stability. Borrowing to fund dividends drains liquidity and increases leverage simultaneously. Such behavior indicates weak financial discipline and is a major qualitative red flag for credit officers.

When a borrower uses debt to fund dividends, the effect on ROE is always positive

FALSE

Using debt to fund dividends can temporarily inflate ROE because equity falls, but it undermines sustainability. As interest expense rises and retained earnings shrink, profitability and coverage ratios deteriorate. Over time, the higher leverage amplifies risk and makes the firm more vulnerable to shocks.

A line-of-credit clean-up clause is designed primarily to help the bank manage itsown liquidity position

FALSE

The clean-up clause exists to test the borrower's cash-flow cycle and confirm the loan supports short-term assets. It is not designed to manage the bank's own liquidity. A successful clean-up demonstrates that inventory and receivables are converting into cash sufficient to retire the line each year.

In DuPont analysis, an increase in financial leverage will always improve ROE, regardless of changes in net income or turnover

FALSE

Higher financial leverage does not automatically improve ROE. It only boosts ROE if the return on assets exceeds the cost of debt. If profitability weakens—as in both case firms—leverage magnifies losses instead of gains.

Sweet Peas' 2018 leverage ratio increased, but this does not necessarily imply greatercredit risk if the new borrowing financed productive assets

TRUE

Sweet Peas' higher leverage in 2018 financed store expansion and is not inherently negative. If the new location generates stronger future cash flows, the incremental debt supports long-term value creation. Credit risk increases only if the investment fails to yield sufficient returns to service that debt.

A long-standing client relationship should always lead a bank to relax its creditstandards

FALSE

Long-standing client relationships should not lead banks to relax standards. While relationship lending provides informational advantages, it can breed complacency and soft budgeting. Traverse Bank must judge the current creditworthiness of Sweet Peas and Inland Lakes, not rely on past performance.

Credit analysis should focus primarily on quantitative ratios, as qualitativeinformation can be unreliable

FALSE

Quantitative ratios alone cannot capture management quality, strategy, or behavioral changes. Qualitative cues—like dividend restraint, transparency, and responsiveness—are essential to interpret numbers correctly. Credit analysis that ignores these factors risks misclassifying temporary versus permanent problems

Which of the following best describes the purpose of a clean-up clause in a line-of-credit agreement?

To verify that the line is financing self-liquidating short-term assets

If a firm repeatedly violates the pay-down requirement, this most likely indicates

Overuse of the line for permanent financing

Sweet Peas' 2018 ROE declined primarily because

Profit margin turned negative due to expansion costs

Inland Lakes' higher dividend payout financed by borrowing would most directly

Increase leverage and reduce retained earnings

Which of the following is the best characterization of Sweet Peas' 2018 performance?

Temporary setback from growth investment

Which ratio would best capture Inland Lakes' worsening liquidity position?

Quick ratio

Why is the DuPont framework useful for credit analysis?

It decomposes ROE into drivers that reveal performance causes

A loan officer approving Sweet Peas' request with conditions is primarily managingwhich risk?

Credit risk

Which of the following would not be an acceptable reason for a temporary violation of the clean-up clause?

A short-term equipment purchase financed through the line

What best distinguishes Inland Lakes' situation from Sweet Peas'?

Inland Lakes' borrowing supported payouts rather than assets

A line of credit is best described as

A revolving facility meant to finance seasonal working capital

Which qualitative factor would most positively influence the credit officer's judgmentof Sweet Peas?

Transparency and willingness to cut dividends during losses

If a firm's ROE increases while its profit margin and asset turnover both decline,what must be true?

Leverage increased enough to offset weaker operations

In the Traverse Bank case, which of the following statements is true?

Sweet Peas' management exhibited prudence and transparency

From a banker's perspective, what is the greatest risk in approving both credit-line increases?

Moral hazard — encouraging poor borrower discipline