CIRA Financial Analysis & Reporting 4 — Questions and Answers
Question 1: The 'absolute priority rule' in bankruptcy governs:
- The order in which assets are liquidated
- The sequence in which creditor classes are paid under a reorganization plan (Correct answer)
- The timing of post-petition interest accruals
- The priority of administrative claims over operating expenses
Correct answer: The sequence in which creditor classes are paid under a reorganization plan
The absolute priority rule requires that senior classes be paid in full before junior classes receive any recovery under a Chapter 11 plan.
Question 2: When calculating free cash flow to the firm (FCFF) for a distressed company, which item must be ADDED BACK to net income?
- Capital expenditures
- Increases in working capital
- Depreciation and amortization (Correct answer)
- Cash interest payments
Correct answer: Depreciation and amortization
Depreciation and amortization are non-cash charges that reduce net income but do not reduce cash, so they must be added back when computing FCFF.
Question 3: An EBITDA margin analysis for a distressed retailer shows margins declining from 12% to 4% over three years. The MOST likely cause consistent with financial distress is:
- Increased depreciation from asset write-ups
- Revenue growth outpacing cost controls
- Rising fixed costs against declining or stagnant revenues (Correct answer)
- Improvement in gross margin from better sourcing
Correct answer: Rising fixed costs against declining or stagnant revenues
Margin compression in distress typically results from fixed costs remaining constant or growing while revenues decline, squeezing profitability.
Question 4: Which of the following items would appear in the 'reorganization items' section of an income statement prepared under ASC 852?
- Cost of goods sold
- Interest expense on pre-petition debt accrued post-petition (Correct answer)
- Write-down of PP&E to net realizable value under ASC 360
- Loss on disposal of discontinued operations
Correct answer: Interest expense on pre-petition debt accrued post-petition
Post-petition interest on pre-petition debt that is disclosed but not necessarily accrued, and adjustments arising from bankruptcy, are classified as reorganization items under ASC 852.
Question 5: In a liquidation analysis, 'forced liquidation value' differs from 'orderly liquidation value' primarily because:
- Forced liquidation assumes assets are sold over a normal marketing period
- Forced liquidation typically produces lower recoveries due to time pressure (Correct answer)
- Orderly liquidation ignores market conditions
- Forced liquidation applies only to real property
Correct answer: Forced liquidation typically produces lower recoveries due to time pressure
Forced liquidation compresses the sale timeline, limiting buyer pool and negotiating leverage, which generally results in lower recovery rates than an orderly process.
Question 6: Which covenant type in a DIP credit agreement typically requires the borrower to maintain minimum EBITDA levels?
- Negative covenant
- Affirmative covenant
- Financial maintenance covenant (Correct answer)
- Reporting covenant
Correct answer: Financial maintenance covenant
Financial maintenance covenants set minimum thresholds for metrics like EBITDA, leverage, and liquidity that must be maintained on a periodic testing basis.
Question 7: A debtor's balance sheet shows total assets of $80M, liabilities subject to compromise of $95M, and post-petition liabilities of $15M. What is the equity (deficit)?
- ($30M) (Correct answer)
- $110M
- ($110M)
- ($30M) deficit
Correct answer: ($30M)
Equity = Total Assets − Total Liabilities = $80M − ($95M + $15M) = $80M − $110M = ($30M) deficit.
CIRA Financial Analysis & Reporting 4
The 'absolute priority rule' in bankruptcy governs: