Chapter 5 Risk Analysis.

Chapter 5Chapter 5Risk AnalysisRisk Analysis

Financial Statement Analysis of RiskTypes of Risk:Financial flexibilityShort-term liquidity riskLong-term solvency riskCredit riskBankruptcy riskMarket equity riskFinancial reporting manipulation risk

Chapter: 05 2

Framework for Financial Statement Analysis of Risk

Chapter: 05 3

Analyzing Financial Flexibility• Financial leverage can enhance the return to

common shareholders.• Disaggregation of ROCE provides insight about

the degree of benefit derived from using leverage.

• Higher leverage generally suggests greater financial risk.

• Risk is primarily attributable to the costs of borrowings.

Chapter: 05 4

Analyzing Financial Flexibility (Contd.)

An alternative disaggregation of ROCE from the one discussed in the previous chapter is:

Chapter: 05 5

sObligation Financing AverageRate Borrowing Net-ROA OperatingSpread

Equity CommonsLiabilitie Total1Leverage

AssetsOperating Net AverageNOPAT ROA Operating

:Where

Spread) x (Leverage ROA Operating ROCE

Analyzing Short-Term Liquidity Risk• Measures a firm’s ability to generate

sufficient cash to supply operating working capital needs and to service debts.

• Short-term liquidity problems can arise from the following:– Untimed cash inflows and outflows.– High Degree of long-term leverage.

Chapter: 05 6

Short-Term Liquidity Risk (Contd.)Financial statement ratios:• Current ratio: It indicates the amount of cash

available and other current assets of the firm, relative to obligations coming due.

• Quick ratio: – Also called as Acid Test Ratio.– Includes in only those current assets the firm could

convert quickly into the cash (Cash, Marketable securities and Receivables).

Chapter: 05 7

Short-Term Liquidity Risk (Contd.)• Operating cash flow to current liabilities: It indicates

the amount of cash from operations after funding working capital needs.

• Working capital activity ratios: Rate of activity measures used to study cash-generating ability of operations and short-term liquidity risk of a firm are:– Accounts Receivable Turnover– Inventory Turnover– Accounts Payable Turnover

Chapter: 05 8

Short-Term Liquidity Risk (Contd.)• Revenues to cash ratio:

– Reflects the net effect of operating, investing, and financing activities on cash and management’s judgments about the desired level of cash.

– Lenders prefer a smaller revenue to cash ratio and large number of days revenue available as cash on hand.

• Days revenue held in cash:– It measures the number of days sales the firm has on

hand as available cash.– It will be useful for forecasting financial statements.

Chapter: 05 9

Analyzing Long-Term Solvency RiskExamines a firm’s ability to make interest and

principal payments on long-term debt and similar obligations.

Three measures used to examining long-term solvency risk are:Debt ratiosInterest coverage ratioOperating cash flow to total liabilities ratio

Chapter: 05 10

Long-Term Solvency Risk (contd.)Debt Ratios:

It is used to measure the amount of liabilities, particularly long-term debt in a firm’s capital structure.

The higher this proportion, the greater the long-term solvency risk.

It is the alternative computation of leveraged used in the ROCE, in previous chapter.

Chapter: 05 11

Long-Term Solvency Risk (contd.)Commonly used measures of Debt Ratios:

Chapter: 05 12

Equity rs’Shareholde TotalDebt Term-Long RatioEquity rs’Shareholde to Debt Term-Long

Equity rs’Shareholde Total Debt Term-LongDebt Term-Long

Ratio Capital Term-Long to Debt Term-Long

Equity rs’Shareholde TotalsLiabilitie Total RatioEquity rs’Shareholde to sLiabilitie

AssetsTotalsLiabilitie Total Ratio Assetsto sLiabilitie

Long-Term Liquidity Risk (Contd.)

• Interest coverage ratio: – It indicates the number of times a firm’s income or

cash flows could cover interest charges.Operating cash flow to total liabilities ratio:

Considers the firms ability to generate cash flow from operations to service debt.

Chapter: 05 13

Analyzing Credit Risk• Potential lenders to a firm, assess the

likelihood that the firm will pay periodic interest and repay the principal amount.

• Lenders may use following checklist as factors.– Circumstances leading to need for loan.– Credit History

• Has a firm borrowed in past and has it successfully repaid it?

• Poor credit history can doom a firm to failure.Chapter: 05 14

Analyzing Credit Risk (contd.)– Cash flows

• Lenders prefer that the firm generates sufficient cash flows to pay interest and repay principal on a loan rather than selling the collateral.

– Collateral– Capacity for debtContingenciesCharacter of ManagementCommunicationConditions or covenants

Chapter: 05 15

Analyzing Bankruptcy Risk• Models for bankruptcy prediction

– Univariate bankruptcy prediction models: Error types

• Examines the relation between a particular financial statement ratio and bankruptcy.

Chapter: 05 16

Analyzing Bankruptcy Risk (Contd.)– Bankruptcy prediction models using multiple

discriminant analysis (MDA): • Altman’s Z-score

– Z less than 1.81 indicates high probability of bankruptcy.– Z greater than 3.00 indicates low probability of bankruptcy.– Scores between 1.81 and 3.00 are in the gray area.

– Bankruptcy prediction models using Logit Analysis:

Chapter: 05 17

ye11 firm a for Bankruptcy ofy Probabilit

Bankruptcy Prediction Research

• It summarizes the factors for bankruptcy most consistently across various studies. – Investment Factors:

• Relative Liquidity of a firm’s Assets• Rate of Asset Turnover

Chapter: 05 18

Bankruptcy Prediction Research (Contd.)

– Financing Factors:• Relative Proportion of Debt• Relative Proportion of Short-term Debt

– Operating Factors:• Relative level of profitability• Variability of operations

– Other possible explanatory variables:• Size• Growth• Qualified Audit Opinion

Chapter: 05 19

Market Equity Beta RiskBeta coefficient measures the covariability of

a firm’s return with the returns of a diversified portfolio of all shares traded on the market.

Beta is a measure of the Systematic risk of the firm.

Chapter: 05 20

Market Equity Beta Risk (Contd.)Studies of the determinants have identified

three principal explanatory variables:Degree of operating leverageDegree of financial leverageVariability of sales

Chapter: 05 21

Financial reporting manipulation risk

• Earnings manipulation- Refers to reporting amounts outside the limits of U.S. GAAP or IFRS, i.e. fraudulent reporting.

• Focus on more flagrant violations of accounting standards and oversight bodies such as FASB, IASB, and SEC.

Chapter: 05 22

Financial reporting manipulation risk

Motivations for financial statement manipulation:Influence stock prices positively.Increase management bonuses.Lower cost debt financing.Avoid violation of debt covenants (or technical

default).Influence corporate control transactions.Avoid regulatory or political consequences.

Chapter: 05 23

Empirical Research on Earnings Manipulation

• Beneish developed a probit model to identify the financial characteristics of firms likely to engage in earnings manipulation.

• Beneish developed both a twelve-factor model36 and an eight-factor model.– The twelve-factor model relies on a combination of

financial statement items and changes in stock prices for a firm’s shares.

– The eight-factor model uses only financial statement items.

Chapter: 05 24