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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A firm has assets with a market value of 300 million and debt with face value 280 million, due in one year. Its cash flow is positive, but it cannot roll over short-term loans. Another firm has assets of 150 million versus debt of 200 million but long-dated debt with no near-term maturities and positive cash flow. Which conclusion is most appropriate?

The first firm has assets above debt, so it is solvent by 20 million, but its inability to roll over loans is a liquidity problem. The second has assets 50 million below debt, so it is balance-sheet insolvent, yet long maturities and positive cash flow avoid an immediate liquidity crisis.

  1. AThe first firm is balance-sheet insolvent and the second is only illiquid
  2. BBoth firms are balance-sheet insolvent and neither is illiquid
  3. CThe first firm is illiquid but solvent on a balance-sheet basis, while the second is balance-sheet insolvent yet not facing a liquidity crisisCorrect
  4. DThe first firm is both insolvent and illiquid, while the second is solvent

Explanation

Firm one: assets 300 exceed debt 280, so equity is positive 20 million (solvent), but it cannot refinance, which is a liquidity problem. Firm two: assets 150 are below debt 200, so equity is negative 50 million (insolvent), yet with long-dated debt and positive cash flow it has no immediate liquidity crisis. Option A reverses the labels.

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