Chapter 9 Risk Analysis

1
Chapter 9 Risk Analysis
2
Accounting risk vs. market risk

• Accounting measures of risk
• short-term liquidity ratios
• long-term solvency ratios
• Market measures of risk
• market beta
• bond ratings
• financial distress

3
Credit Risk

• A firms ability to make interest and principal
  payments on borrowings
• loans from financial institutions (banks,
  insurance companies, finance companies)
• commercial paper (banks, mutual funds, other
  companies)
• bonds
• suppliers

4
Credit risk analysis

• Circumstances (purpose)
• ongoing activities
• expansion
• product development
• other problems
• Cash flows
• watch growth rates of debit balance accounts vs.
  credit balance accounts
• capital expenditures, dividend payments
• sale of securities
• shift from long-term to short-term borrowing

5
Credit risk analysis, contd

• Cash flow ratios
• CFO to Average Current Liabilities gt 40
• CFO to Average Total Liabilities gt 20
• CFO to Capital Expenditures lt 1 gtgt means that
  the firm will have to find outside funding
• Collateral
• marketable securities
• accounts receivable
• inventories
• property, plant, equipment

6
Credit risk analysis, contd

• Capacity for Debt - excess debt capacity
  signifies a margin of safety
• debt ratios higher ratios mean lower excess
  debt capacity and higher risk
• interest coverage ratios lt 2 are usually indicate
  little additional debt capacity and are
  considered high risk ratios gt 4 usually
  indicate excess debt capacity
• Contingencies - liabilities which are not yet
  certain
• lawsuits, loan guaranties, derivatives
• dependence on a few employees, contracts,
  licenses, raw materials

7
Bankruptcy risk

• Bankruptcy prediction models - use one or more
  financial ratios to predict bankruptcy filing one
  to five years in the future
• Altmans Z-score (manufacturing firms)
• Net Working Capital / Total Assets
• Retained Earnings / Total Assets
• Earnings before Interest Taxes / Total Assets
• Market Value of Equity / Book Value of
  Liabilities
• Sales / Total Assets
• Z-scores lt 1.8 indicate high probability of
  bankruptcy
• Z-scores gt 3.0 indicate low probability of
  bankruptcy

1.2 1.4 3.3 0.6 1.0
8
Problems with MDA analysis

• Cannot be certain that the ratios capture the
  discriminating data
• firms do not always disclose sufficient data
• Interpretation of score can require significant
  amounts of judgment
• Statistical concerns
• assumes normal distribution of ratios
• firms in distress often have highly skewed ratios
• assumes bankrupt and non-bankrupt firms display
  the same relationship to ratios

9
Bankruptcy risk

• Logit analysis - free from statistical
  assumptions of MDA models indicates the
  probability of bankruptcy
• Probability ____1____
  1 e -y
• e 2.718282
• y multivariate function that
  includes a constant and
  coefficients for a set of
  financial ratios

10
Logit analysis, contd

• Size Natural Log of Total Assets / GNP Price
  Deflator (1978)
• Total Liabilities / Total Assets
• (Current Assets - Current Liabilities) / Total
  Assets
• Current Liabilities / Current Assets
• Net Income / Total Assets
• Working Capital from Operations / Total
  Liabilities
• Negative income variable (1 negative for last
  two years, else 0)
• Excess of Total Liabilities over Total Assets (1
  excess, else 0 )
• Change in net income (NI t - NI t-1 ) / (NI
  t NI t-1 )
• The smaller the e value, the greater the
  likelihood of bankruptcy

11
Market risk

• Capital Asset Pricing Model (CAPM) - relates a
  companys returns on common (dividends plus
  capital gains) to returns in excess of the risk
  free rate for all common stocks
• Beta - captures the systematic risk of a firm
• explained through degree of operating leverage,
  degree of financial leverage, variability of
  sales
• different industries have different betas

12
TheEnd