Risk Analysis

Lecture 4

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Sources and Types of Risk

Source Type or Nature

International Host government regulations and attitudesPolitical unrestExchange rate changes

Domestic RecessionInflation or deflationInterest rate changesPolitical changes

Industry TechnologyCompetitionRegulationAvailability of raw materialsLabor and other input price changesUnionization

Firm-Specific Management competenceStrategic directionLawsuits

Five types of risk Short-term liquidity risk

Ability to generate cash to service working capital requirements Long-term solvency risk

Ability to generate cash internally or externally to meet long-term capacity requirements

Credit risk Ability to service debt payments

Bankruptcy risk Continuing ability to meet all obligations (avoiding default on

loans, avoiding default on payments to suppliers and so forth) Market equity risk

How risky a company’s stock is relative to other securities in the market

A “combined” measure of risk from the equityholder’s perspective A common measure is beta – covariability of a firm’s returns with

the returns of all securities in the market

Framework for Financial Statement Analysis of Risk

Ability Ability to Generate Cash Need to Use Cash Financial Statement Analysis Performed

Operating Profitability of goods Working capital Short-term and services sold Requirement liquidity risk

Investing Sales of existing plant Plant capacity Long-term assets or investments Requirement solvency risk

Financing Borrowing capacity Debt service Long-term Requirement solvency risk

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Analyzing Short-Term Liquidity Risk Require an understanding of the operating cycle of a firm. Relates to the timing and relative magnitudes of cash

inflows and outflows in the short-run. We would expect a company to have net cash inflows over

time However, difficult to time inflows and outflows such that there

is always no cash crunch Unexpected bottlenecks Sudden spurts or lulls in demand Unexpected delays in cash collection Unexpected pressures from suppliers to pay up

Timing cashflows is more difficult in some industries relative to others

So need to maintain a greater cash buffer or reserve in some companies/industries relative to others

Firms with high levels of debt requiring high levels of interest payments also need to maintain more liquidity

Financial Ratios for assessing short-term liquidity risk Current Ratio Quick Ratio Operating Cash Flows to Current

Liabilities Ratio Working Capital Activity Ratios

Accounts receivable turnover Inventory turnover Accounts payable

Current Ratio

How current assets relate to current liabilities In excess of one? Depends on inventory management Depends on the ability to quickly raise short-

term credit when needed (such as unused line of credit)

High current ratio may actually signal unfavorable business conditions

No “optimal” levels; industry practice often the best benchmark

Can be managed!

Quick Ratio

Also called acid test ratio A measure of ability to discharge

current liabilities, quickly Take out from current assets items

that are less liquid such as inventories

Also subject to some of the same concerns as the current ratio

Operating Cash Flows to Current Liabilities Ratio

Ability to generate cash flows from operations to meet current obligations

Operating cash flows is what remains after funding working capital needs

Higher this ratio, the greater is the “cushion” that a firm has

Together with current and quick ratios, this ratio helps in assessing short-term liquidity risk better

Working Capital Activity Ratios Speed with which firm converts accounts receivable to

cash Speed with which firm turns over inventories Speed with which firm pays its suppliers Determine the amount of working capital necessary to

finance operations Days of working capital needed from external sources =

Days inventory held + days of accounts receivable outstanding – days of accounts payable outstanding

A smaller number of days indicates less need for external financing

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Analyzing Long-Term Solvency Risk

Recall thatROE = Op. ROA

+ (Op. ROA – Net Borrowing Rate) x Net Fin. Leverage

= Op. ROA + Spread x Net Fin. Leverage If Spread >0 (<0), the gain (loss) in ROE from financial

leverage increases with Net Fin. Leverage Financial leverage therefore enhances ROE when

operating ROA is greater than net borrowing rate As the proportion of debt increases, the risk that the

firm cannot pay interest and repay principal also increases

Unless the firm has the ability to generate sufficient earnings over a period of years

So, how do we assess long-term solvency risk?

Analyzing Long-Term Solvency Risk

Ability to generate sufficient earnings over the long-term

Profitability Debt ratios

Long-term debt ratio (typically less than 1) Debt-equity ratio Liabilities to assets ratio (typically less than 1)

Interest coverage ratio Earnings before interest and taxes/interest Can generalize to other fixed payment obligations as well

(fixed charges coverage ratio) Operating cash flows to total liabilities

Explicitly considers a company’s ability to generate cash Problem 5.3

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Analyzing credit risk

Circumstances Leading to Need for the Loan Why is the loan being sought?

To smooth over seasonal fluctuations? To “bridge” timing differences between

cash outflows and inflows? To pay off other debt? To fund new product development in

order to stay in business (National semiconductor example)

Analyzing credit risk Cash Flows

Cash flow generating ability. Look for weaknesses in cash flow statements:

Unusual/inexplicable increases in accounts receivable High levels of accounts payable Upward trend in other liabilities Negative cash flows from operations Capital expenditures in excess of cash flows Declining capital expenditures Liquidating current assets such as marketable securities Cutting dividends

Ratio Cash flows from operations to average current liabilities Cash flows from operations to average total liabilities

Projected cash flow statements Ability to service loans and repay loans in the future

Analyzing credit risk Collateral

Marketable securities, Accounts receivable, Inventories, Fixed assets

Capacity for Debt Existing level of debt (high debt ratios) Margin of safety available in interest coverage

Contingencies Commitments of the firms that could give rise to

claims on future cash flows Character of Management Conditions

Covenants or conditions placed by existing/senior lenders

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Analyzing bankruptcy risk

Firms enter bankruptcy when there is not enough cash to immediate claims of creditors

Insufficient liquidity To avoid costly labor renegotiations To avoid costly litigation

Bankruptcy prediction models based on select financial statement ratios

Investment factors (asset side) Relative liquidity of a firm’s assets Asset turnover rates

Financing factors (liability side) Leverage Proportion of short-term debt in capital structure

Operations Profitability Volatility

Trends in these ratios can signal impending bankruptcy So lenders, creditors and shareholders can make informed decisions in

supplying capital and credit facilities

How do bankruptcy prediction models work?

Take a sample of firms that went bankrupt Match these firms with non-bankrupt firms of the same size

and in the same industry

Year 0Year -2 Year -1

Align all firms on the bankruptcy year (Year 0) Compute relevant financial statement ratios a priori for

bankrupt and matching firms in years -2, -1 Use appropriate methodology to examine/select ratios that

discriminate between and non-bankrupt firms Methods used

Multi-discriminant analysis Logit (which provides an estimate of the probability that a firm will

go bankrupt)

Multi-discriminant Analysis A way to look at multiple ratios simultaneously Easy to apply Provides a model to assess bankruptcy Can make Type I or Type II errors

Type I error: Classifying a potential bankrupt firms incorrectly as non-bankrupt firm

Type II error: Classifying a potential non-bankrupt firn incorrectly as a bankrupt firm

Which error is costlier? The best known bankruptcy prediction model

is Altman’s z-score

Altman’s Z-ScoreZ-Score = 1.2 [ Net working Capital/ Total Assets]

+ 1.4 [ Retained Earnings/ Total Assets] + 3.3 [Earnings Before Interest and Taxes/ Total Assets] + 0.6 [ Market Value of Equity/ Book Value of Liabilities] + 1.0 [ Sales/ Total Assets]

How to use it? Calculate the ratios on the right hand side of the equation Plug these values in the equation and calculate the z-score Z-score > 3 indicates low probability of bankruptcy

Z-score between 1.8 and 3 is gray area Z-score less than 1.8 indicates high probability of bankruptcy

Note: For this class, we will not use Ohlson’s Logit Model. Let us just use Altman Z-score.

Issues with Bankruptcy Prediction Models

The model is only as good as the “match” firm Stability of models over time Need to update the coefficients and even the specific

ratios used. Problem 5.5

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Market Equity Beta Risk A broader measure of risk from an equity market

perspective Beta –

A measure of covariance of firm’s returns with returns of other securities traded in the market

A measure of how risky is a firm’s stock relative to the market

Beta = 1 implies the stock is of similar risk Beta > 1 implies the stock is of a higher risk (expected return is

higher) Beta < 1 implies the stock is of a lower risk (expected retrun is

lower) Often referred to as the “Systematic risk”

Determinants of Beta Operating leverage Degree of financial leverage Demand variability

Topics

Framework for Risk Analysis Analyzing Short-Term Liquidity Risk Analyzing Long-Term Solvency Risk Analyzing Credit Risk Analyzing Bankruptcy Risk Market Equity Beta Risk Financial Reporting Manipulation Risk

Motivations for Earnings Manipulation

Saving debt financing cost by showing more profitable or less risky.

Positively influence stock prices, or delay inevitable stock price declines.

Increase performance-based management compensation.

Avoid violation of debt covenants.

Beneish’s earnings manipulation model

Case 5.3 List of recent bankruptcies