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Chapter 5, Slide #1 Financial Reporting, Financial Statement Analysis, and Valuation: A Strategic Perspective Sixth Edition Stickney/Brown/Wahlen Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5 Risk Analysis Slides Prepared by Karen Foust Tulane University

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Chapter 5, Slide #2 Risk Analysis Types Short-term liquidity Long-term solvency Credit risk Bankruptcy risk Financial reporting manipulation risk

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Chapter 5, Slide #3 Framework for Risk Analysis

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Chapter 5, Slide #4 Short-Term Liquidity Risk Tools: Current ratio = current assets/current liabilities Quick ratio = cash+mktble securities+receivables current liabilities

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Chapter 5, Slide #5 Short-Term Liquidity Risk Operating Cash Flow to Current Liabilities = Cash Flow from Operations Average Current Liabilities Working Capital Activity Ratios –Accounts Receivable Turnover –Inventory Turnover –Accounts Payable Turnover

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Chapter 5, Slide #6 Short-Term Liquidity Risk Days of Working Capital Financing Needed: Days Inventory Held + Days A/R Outstanding less Days A/P Outstanding = Days of Working Capital Financing Needed. Revenues to Cash Ratio: Revenues Average Cash Balance

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Chapter 5, Slide #7 Long-Term Solvency Risk Debt Ratios Long-term debt = Long-term debt L/T debt + S/H Equity Debt/Equity Ratio = L/T debt S/H Equity Liabilities to Assets Ratio = Total Liabilities Total Assets

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Chapter 5, Slide #8 Long-Term Liquidity Risk Interest coverage ratio: Net income + interest exp + income tax exp + minority interest in earnings Interest expense Operating cash flow to total liabilities: Cash flow from operations Avg total liabilities

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Chapter 5, Slide #9 Credit Risk Circumstances –Ongoing operations? –Operating problems, emerging businesses, investment in intangibles – all riskier... Cash Flows –Can the firm generate the cash to repay? –A/R or Inventories growing faster than sales? –A/P increase > increase in inventories? –Consistent negative CFOA?

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Chapter 5, Slide #10 Credit Risk (cont.) Cash Flows (cont.) –Capital expenditures > CFOA? –Decline in capital expenditures? –Sales of mktble securities > purchases? –Shift from L/T to S/T borrowing? –Reduced dividend payments?

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Chapter 5, Slide #11 Credit Risk (cont.) Collateral Marketable securities Accounts receivable Inventories Property, plant & equipment Capacity for debt Debt ratios Interest coverage ratio

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Chapter 5, Slide #12 Credit Risk (cont.) Contingencies Character of Management Conditions Debt covenants

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Chapter 5, Slide #13 Bankruptcy Risk Altman’s Z-score –Z less than 1.81 indicates high probability –Z greater than 3.00 indicates low probability Error types –Type I: class firm as nonrisk, ultimately does go bankrupt –Type II: class as bankrupt, remains viable

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Chapter 5, Slide #14 Bankruptcy Prediction Investment Factors –Relative Liquidity of Assets cash/total assets current assets/total assets net working capital/total assets or fixed assets/total assets –Rate of Asset Turnover total assets turnover accounts receivable turnover inventory turnover

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Chapter 5, Slide #15 Bankruptcy Prediction Financing Factors –Relative Proportion of Debt total liabilities/total assets total liabilities/shareholders’ equity –Relative Proportion of Short-term Debt current liabilities/total assets

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Chapter 5, Slide #16 Operating Factors –Relative profitability net income/assets income before interest and taxes/assets net income/sales cash flows from operations/assets –Variability of operations cyclical sales patterns Bankruptcy Prediction

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Chapter 5, Slide #17 Bankruptcy Prediction Other factors –Size –Growth –Qualified Audit Opinion

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Chapter 5, Slide #18 Market Equity Beta Risk Systematic risk of the firm Three principal explanatory variables: –Degree of operating leverage –Degree of financial leverage –Variability of sales

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Chapter 5, Slide #19 Manipulation Risk Reporting amounts outside the limits of generally accepted accounting principles (GAAP) That is, fraudulent reporting

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Chapter 5, Slide #20 Manipulation Risk Motivations for financial statement manipulation: Lower cost debt financing Increase stock prices Increase management bonuses Avoid violation of debt covenants (or technical default) Influence corporate control transactions Avoid regulatory or political consequences

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