Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Risk Analysis Slides Prepared by Karen Foust Tulane University

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

Framework for Risk Analysis

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

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

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

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

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

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?

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?

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

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

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

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

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

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

Other factors –Size –Growth –Qualified Audit Opinion

Market Equity Beta Risk Systematic risk of the firm Three principal explanatory variables: –Degree of operating leverage –Degree of financial leverage –Variability of sales

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

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