It is to determine risk from the balance sheet Presented by: Priscilla Wong ( ) Carmen Wong ( ) Carly Wong ( )

Outline What is Balance Sheet? Use of Balance Sheet What is risk? Types of risk we would talk about Possibility to determine risk from Balance Sheet Conclusion Sources to determine risk

Balance Sheet Financial statement of position List of all assets, liability & owner s equity A single date, not a period of time One of the main documents legally required to be produced by companies as part of the annual report

Use of Balance Sheet Provide information to assess the financial position at a particular point in time Summarize information in a clear & intelligible form Classify items in an appropriate manner to show the strength of the enterprise Indicate relative liquidity of assets & liability Evaluate financial position at a particular point of time

Use of Balance Sheet Provide information to assess the financial position at a particular point in time Summarize information in a clear & intelligible form Classify items in an appropriate manner to show the strength of the enterprise Indicate relative liquidity of assets & liability Evaluate financial position at a particular point of time

Question of Balance Sheet Is the information in Balance Sheet useful to investor and other users?

Question of Balance Sheet Is it information in Balance Sheet useful to investor and other users?

Investors concern Rational investors must consider: expected return expected risk for a given level of expected return, an investor will seek to minimize risk for a given level of expected risk, an investor will seek to maximize return

Expected Return It can be obtained from the financial statement easily For example, net income can be obtained from balance sheet from the change in retained earning

Expected Risk But Balance Sheet does not reflect any risk information directly

Risk Risk & financial reporting: A summary of the discussion at the 1997 AAA/FASB conference Risk is difficult to define because different financial users value information about different types of risk Probability that events will differ from what has predicted risk is unforeseen Risk is difficult to assess due to uncertainty

Types of Risk Business Risk (external) Operating Risk (internal) Financial Risk (numerical)

Business Risk Risk related to the company s industry External to the business entity itself Influence on the entity Nature of the business

Business Risk Technology faced by the company Availability of product substitutes Level of domestic and international involvement Robustness of demand for products Overall diversification policy Capital/labour mixture

Business Risk Relations with trade unions Size and wealth Reputation of name and product Extent and nature of government intervention Nature of legislation faced Impact on the physical environment Growth

Business Risk Difficult to quantify Subjective to each person Risk on the other hand may be chance Help development of business in the future Not appear in Balance Sheet can t be measured by Balance Sheet

Operating Risk Risk associated within the operation of the company Different form the business risk Business risk related to the nature of the industry Operating risk related to the operation of that specified firm

Operating Risk For example, employee royalty turnover rate hinder operation recruit new people require time and training sales and profit Risk

Operating Risk If the major customer is lost Financial difficulty may be resulted We are encountering a financial problem… may go into liquidation…

Operating Risk Old production process Ineffective for production Cost & fail to meet customer demand on time Customer switch to other supplier Sale and profit risk

Operating Risk Operating activities of management related to the performance of the company directly change the investment decision of investors However, Investors cannot obtain the operating information from the balance sheet easily Reason: information asymmetry

Operating Risk Operation risk is difficult to assess Not enough information Difficult to quantify objectively Uncertain about the time and amount of possible financial loss Not easy to determine

Financial Risk Risk imposed on the business by the use of debt finance (capital structure) Related to the numerical data

Financial Risk Consider the capitalization structure Ability to service existing structure Sufficient profits to protect debt covenant violation Sufficient cash to pay interest when due and dividend Ability to maintain or alter present structure Maintain present dividend policy Issue new securities

Financial Risk Number itself may not reflect risk directly Measured by: financial ratios trend analysis

Financial Ratio Current ratio = current assets/current liabilities Quick ratio = (current assets – inventory)/current liabilities The lower of current ratio & quick ratio financial risk not enough liquid asset to meet the debt obligation

Financial Risk Total debt ratio = total liabilities/total assets The higher of total debt ratio financial risk the capital structure of firm is not so sound

Financial Ratio Dividend pay out ratio = Dividend/Retained profit The lower the dividend pay out ratio financial risk not enough cash to pay out the dividend

Financial Ratio Financial leverage = total debt/total equity The higher the gearing ratio financial risk use too much debt to finance its operation pay huge amount of interest may not able to repay the debt

Financial Ratio Financial leverage = total debt/total equity The higher the gearing ratio financial risk use too much debt to finance its operation pay huge amount of interest may not able to repay the debt

Financial Ratio However … Short-term debt finance long term assets? Current assets really convertible into cash? Ratios calculated as on the balance sheet date timely to show the financial situation of the company now? Problem of interpretation as income statement information is not taken into account

Trend Analysis Technique used for time periods in excess of 2 or more years Make results easier to understand and interpret Projection of the accounting figures indicate the risk faced by the company

Trend Analysis However … Balance sheet not consider effects of price changes E.g. inflation Make comparisons difficult unless adjustment

Trend Analysis Impacts of changes in technology on price of assets not reflected Some assets depreciates faster, e.g. computers But, consistent depreciation policy is applied Undervaluation of assets Risk associated with technology changes cant be assessed through balance sheet!!

Trend Analysis Impacts of industry environment not reflected in Balance Sheet Balance sheet reflects information of one company, not whole industry Superior performance may not be due to good performance of that company, but due to the good performance of the whole industry

Trend Analysis Accounting policies not applied consistently Comparison not available Interpretation misleading

Trend Analysis Accounting policies not applied consistently Comparison not available Interpretation misleading

Trend Analysis Financial information across companies within same industry Different company different size, different risks, different accounting policies comparison meaningless risk wrongly assessed

Trend Analysis Financial information across companies within same industry Different company different size, different risks, different accounting policies comparison meaningless risk wrongly assessed

Conclusion Risk is very difficult to measure from Balance Sheet only because: Balance sheet does not have sufficient information to measure risk Balance sheet show a particular point of time only Bias More complete risk measurement together with income statement and cash flow statement for financial risk

Conclusion Not every risk can be quantified objectively Risk full of uncertainty When and how much the risk would happen Difficult to determine risk

Determination of risk from Balance Sheet

Sources to Determine Risk Government Statistics overall economic situation & industry situation Trade journals the general situation of the overall industry Growing? Declining?

Sources to Determine Risk Government Statistics overall economic situation & industry situation Trade journals the general situation of the overall industry Growing? Declining? More understanding on the industry assists more accurate risk determination.

Sources to Determine Risk Annual report Income statement & Cash flow statement & Balance Sheet: Financial information Overall performance prediction of future risk more accurately

Sources to Determine Risk Annual report: Chairman s Statement Director s report the forthcoming challenges the firm is ready to face company s confidence towards the challenges

Sources to Determine Risk Management behaviour change in dividend policy E.g. Sudden drop in common dividend to zero Failure to cover preferred dividends company short of cash

Sources to Determine Risk Management behaviour change in dividend policy E.g. Sudden drop in common dividend to zero Failure to cover preferred dividends company short of cash