Chapter 5

Risk Analysis

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 Financial Statement Analysis of Risk
Types of Risk:
 Financial flexibility
 Short-term liquidity risk
 Long-term solvency risk
 Credit risk
 Bankruptcy risk
 Market equity risk
 Financial reporting manipulation risk

Chapter: 05 2
 Framework for Financial Statement
Analysis of Risk

Chapter: 05 3
 Analyzing Financial Flexibility
 Financial leverage can enhance the return
to common shareholders.
 Disaggregation of ROCE provides insight
about the degree of benefit derived from
using leverage.
 Higher leverage generally suggests greater
financial risk.
 Risk is primarily attributable to the costs of
borrowings.
Chapter: 05 4
 Analyzing Financial Flexibility (Contd.)
An alternative disaggregation of ROCE
from the one discussed in the previous
chapter is:
ROCE  Operating ROA  (Leverage x Spread)

Where :
NOPAT
Operating ROA 
Average Net Operating Assets
Total Liabilities
Leverage  1 
Common Equity
Operating ROA - Net Borrowing Rate
Spread 
Chapter: 05 Average Financing Obligations 5
 Analyzing Short-Term Liquidity Risk
 Measures a firm’s ability to generate
sufficient cash to supply operating working
capital needs and to service debts.
 Short-term liquidity problems can arise
from the following:
 Untimed cash inflows and outflows.
 High Degree of long-term leverage.

Chapter: 05 6
 Short-Term Liquidity Risk (Contd.)
Financial statement ratios:
 Current ratio: It indicates the amount of cash
available and other current assets of the firm,
relative to obligations coming due.
 Quick ratio:
 Also called Acid Test Ratio.
 Includes only those current assets the firm could
convert quickly into cash (Cash, Marketable
Securities & Receivables).

Chapter: 05 7
 Short-Term Liquidity Risk (Contd.)
 Operating cash flow to current liabilities: It
indicates the amount of cash from operations
after funding working capital needs.
 Working capital activity ratios: Rate of activity
measures used to study cash-generating ability
of operations and short-term liquidity risk of a
firm are:
 Accounts Receivable Turnover
 Inventory Turnover
 Accounts Payable Turnover
Chapter: 05 8
 Short-Term Liquidity Risk (Contd.)
 Revenues to cash ratio:
 Reflects the net effect of operating, investing, and
financing activities on cash and management’s
judgments about the desired level of cash.
 Lenders prefer a smaller revenue to cash ratio and
large number of days revenue available as cash on
hand.
 Days revenue held in cash:
 It measures the number of days sales the firm has on
hand as available cash.
 It will be useful for forecasting financial statements.
Chapter: 05 9
 Analyzing Long-Term Solvency Risk
 Examines a firm’s ability to make interest
and principal payments on long-term debt
and similar obligations.
 Three measures used to examining long-
term solvency risk are:
 Debt ratios
 Interest coverage ratio
 Operating cash flow to total liabilities ratio

Chapter: 05 10
 Long-Term Solvency Risk (contd.)
 Debt Ratios:
 Used to measure the amount of liabilities,
particularly long-term debt in a firm’s capital
structure.
 The higher this proportion, the greater the
long-term solvency risk.
 The alternative computation of leverage used
in the ROCE, in previous chapter.

Chapter: 05 11
 Long-Term Solvency Risk (contd.)
 Commonly used measures of Debt
Ratios:
Total Liabilitie s
Liabilitie s to Assets Ratio 
Total Assets

Total Liabilitie s
Liabilitie s to Shareholde rs’ Equity Ratio 
Total Shareholde rs’ Equity

Long - Term Debt to Long - Term Capital Ratio

Long - Term Debt

Long - Term Debt 
Total Shareholde rs’ Equity

Long - Term Debt

Long - Term Debt to Shareholde rs’ Equity Ratio 
Total Shareholde rs’ Equity

Chapter: 05 12
 Long-Term Liquidity Risk (Contd.)
 Interest coverage ratio:
 It indicates the number of times a firm’s
income or cash flows could cover interest
charges.
 Operating cash flow to total liabilities ratio:
 Considers the firm’s ability to generate cash
flow from operations to service debt.

Chapter: 05 13
 Analyzing Credit Risk
 Potential lenders to a firm assess the
likelihood that the firm will pay periodic
interest and repay the principal amount.
 Lenders may use the following checklist as
factors:
 Circumstances leading to need for loan.
 Credit History
 Has a firm borrowed in the past and has it
successfully repaid it?
 Poor credit history can doom a firm to failure.
Chapter: 05 14
 Analyzing Credit Risk (contd.)
 Cash flows
 Lenders prefer that the firm generates sufficient
cash flows to pay interest and repay principal on a
loan rather than selling the collateral.
 Collateral
 Capacity for debt
 Contingencies
 Character of Management
 Communication
 Conditions or covenants
Chapter: 05 15
 Analyzing Bankruptcy Risk
 Models for bankruptcy prediction
 Univariate bankruptcy prediction models: Error
types
 Examines the relation between a particular financial
statement ratio and bankruptcy.

Chapter: 05 16
 Analyzing Bankruptcy Risk (Contd.)
 Bankruptcy prediction models using multiple
discriminant analysis (MDA):
 Altman’s Z-score
 Z less than 1.81 indicates high probability of bankruptcy.
 Z greater than 3.00 indicates low probability of
bankruptcy.
 Scores between 1.81 and 3.00 are in the gray area.
 Bankruptcy prediction models using Logit
Analysis:
1
Probability of Bankruptcy for a firm 
1  e y
Chapter: 05 17
 Bankruptcy Prediction Research
 Summarizes the factors for bankruptcy
more consistently across various studies.
 Investment Factors:
 Relative Liquidity of a firm’s Assets

 Rate of Asset Turnover

Chapter: 05 18
Bankruptcy Prediction Research
(Contd.)
 Financing Factors:
 Relative Proportion of Debt
 Relative Proportion of Short-term Debt

 Operating Factors:
 Relative level of profitability
 Variability of operations

 Other possible explanatory variables:

 Size
 Growth
 Qualified Audit Opinion

Chapter: 05 19
 Market Equity Beta Risk
 Beta coefficient measures the covariability
of a firm’s return with the returns of a
diversified portfolio of all shares traded on
the market.
 Beta is a measure of the systematic risk
of the firm.

Chapter: 05 20
 Market Equity Beta Risk (Contd.)
 Studies of the determinants have identified
three principal explanatory variables:
 Degree of operating leverage
 Degree of financial leverage
 Variability of sales

Chapter: 05 21
 Financial reporting manipulation risk
 Earnings manipulation - Refers to reporting
amounts outside the limits of U.S. GAAP
or IFRS, i.e. fraudulent reporting.
 Focus on more flagrant violations of
accounting standards and oversight bodies
such as FASB, IASB, and SEC.

Chapter: 05 22
 Financial reporting manipulation risk
 Motivations for financial statement
manipulation:
 Influence stock prices positively.
 Increase management bonuses.
 Lower cost debt financing.
 Avoid violation of debt covenants (or technical
default).
 Influence corporate control transactions.
 Avoid regulatory or political consequences.
Chapter: 05 23
 Empirical Research on Earnings
Manipulation
 Beneish developed a probit model to identify the
financial characteristics of firms likely to engage
in earnings manipulation.
 Beneish developed both a twelve-factor model
and an eight-factor model.
 The twelve-factor model relies on a combination of
financial statement items and changes in stock prices
for a firm’s shares.
 The eight-factor model uses only financial statement
items.

Chapter: 05 24