1. 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

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 –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 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 –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. 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

17. 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