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

2. Risk Analysis Types Short-term liquidity Long-term solvency
Credit risk
Bankruptcy risk
Financial reporting manipulation risk

3. Framework for Risk Analysis

4. Short-Term Liquidity Risk
Tools:
Current ratio =
current assets/current liabilities
Quick ratio =
cash+mktble securities+receivables
current liabilities

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

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

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

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

9. Credit Risk Circumstances Cash Flows 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?

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?

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

12. Credit Risk (cont.) Contingencies Character of Management Conditions
Debt covenants

13. Bankruptcy Risk Altman’s Z-score Error types
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

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

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

16. Bankruptcy Prediction
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

17. Bankruptcy Prediction
Other factors
Size
Growth
Qualified Audit Opinion

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

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

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