Chapter 5

Risk Analysis

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Financial Statement Analysis of Risk

Types of Risk:
Financial flexibility
Short-term liquidity risk
Long-term solvency risk
Credit risk
Bankruptcy risk
Market equity risk
Financial reporting manipulation risk
Chapter: 05

Framework for Financial Statement

Analysis of Risk

Chapter: 05

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

Analyzing Financial Flexibility (Contd.)

An alternative disaggregation of ROCE
from the one discussed in the previous
chapter is:
ROCE Operating ROA (Leverage x Spread)
Where :
NOPAT
Average Net Operating Assets
Total Liabilities
Leverage 1
Common Equity
Operating ROA - Net Borrowing Rate
Spread
Average Financing Obligations
Chapter: 05
Operating ROA

Analyzing Short-Term Liquidity Risk

Measures a firms 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

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 & Receivables).
Chapter: 05

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

Short-Term Liquidity Risk (Contd.)

Revenues to cash ratio:
Reflects the net effect of operating, investing, and

financing activities on cash and managements

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

Analyzing Long-Term Solvency Risk

Examines a firms ability to make interest

and principal payments on long-term debt

and similar obligations.
Three measures used to examining longterm solvency risk are:
Debt ratios
Interest coverage ratio
Operating 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 firms 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:
Liabilities to Assets Ratio

Total Liabilities
Total Assets

Liabilities to Shareholde rs Equity Ratio

Total Liabilities
Total Shareholde rs Equity

Long - Term Debt to Long - Term Capital Ratio

Long - Term Debt

Long - Term Debt Total Shareholde rs Equity

Long - Term Debt to Shareholde rs Equity Ratio

Chapter: 05

Long - Term Debt

Total Shareholde rs Equity
12

Long-Term Liquidity Risk (Contd.)

Interest coverage ratio:
It indicates the number of times a firms

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 debt
Contingencies
Character of Management
Communication
Conditions 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):

Altmans

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:

1
Probability of Bankruptcy for a firm
1 e y
Chapter: 05

17

Bankruptcy Prediction Research

It summarizes the factors for bankruptcy

most consistently across various studies.

Investment Factors:
Relative

Liquidity of a firms 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 Risk

Beta coefficient measures the

covariability of a firms 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 leverage
Degree of financial leverage
Variability 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 firms shares.
The eight-factor model uses only financial statement
items.
Chapter: 05

24