Risk

Management
Meeting Point 14
Concept of Risk
• Risk involvers exposures to as specified type of loss
Specific Risk

Financial Short-term Long-term Credit Risk Bankruptcy Systematic

Flexibility Liquidity Risk Solvency Risk Risk Risk

Measures of Risk Related to External Investors and Creditors

Severity of Various Credit-Related Events to
A Firms’s Investors

Not Less More Very

Severe Severe Severe Severe
Stretching Falling to Make A Defaulting on
Out Trade Required Interest Restructuring Principal Liquidating The
Payables Payment on Time Debt Payment on Firm
Debt
Disclosures Regarding Risk and Risk
Management-cont’d
Firm-Specific
• Ability to attract, retain, and motivate employees
• Dependence on one or few customers
• Dependence on one or few suppliers
• Environmental or political scrutiny
• litigation

Industry
• Availability and price of raw materials or other products inputs
• Competition
• Technology
• Regulation
• Labor Wages and Supply
Disclosures Regarding Risk and Risk
Management
Domestic
• Political environment
• Recessions
• Inflation or deflation
• Interest rate volatility
• Demographic shifts

International
• Exchange rate volatility
• Host government regulations and posturing
• Political unrest or asset expropriation
 Example for Risk
Disclosure in
Starbuck Financial
Reports 2023
Risk Disclose
• Under the Form 10-K
Firms-Specific Risks

(Page: 11)

(Page: 12)

(Page: 13)
…meanwhile, in Management’s Discussion
and Analysis
Foreign Exchange
Changes in foreign exchange rate can affect a firm in multiple ways,
including:
• Amounts paid to acquire raw materials from suppliers abroad
• Amounts received for products sold to customers abroad
• Amounts collected from an account receivable, a loan receivable, or
another payable denominated in a foreign currency
• Amounts collected from remittances from a foreign branch or dividends
from a foreign subsidiary
• Cash-equivalent value of assets invested abroad and liabilities borrowed
abroad in the event the firm liquidates a foreign subsidiary
 Changes in interest rates can affect:

Interest Rates • The fair value of investments in bonds, investment securities, loans, and receivables
with fixed interest rates, as well as liabilities with fixed interest rates
• Returns a firm generates from pension fund investments
Other Risk-
Related
Disclosures
Analyzing Financial Flexibility by Disaggregating
ROCE

ROCE = Profit Margin for ROCE X Assets X Capital Structure

Turnover Leverage
Reformulation of Standard Balance Sheet into Net Operating Assets, Financing Obligations, and
Common Equity Components
Assets
Operating Assets + Financing Assets
Operating Assets – Operating Liabilities
Net Operating Assets
• Cash needed for liquidity
• Accounts payable
• Accounts receivable
• Accrued liabilities
• Prepaid Assets
• Deferred income tax liabilities
• Inventory
• Other liabilities
• Property, plant, and equipment
• Intangible assets
• Deferred income tax assets
• Investment Securities
• Other assets
= Liabilities + Equity
= Operating Liabilities + Financing Liabilities + Common Equity
= Financing Liabilities – Financing Assets + Common Equity
= Net Financing Obligations + Common Equity
• Short-term and long-term debt • Common Equity
• Excess cash
• Preferred equity
• Restricted cash for Debt Covenants
• Non-controlling interests
• Bond sinking funds
• Investment securities for financial purposes
SOURCES OF DEBT AND EQUITY FINANCING
THAT GENERATE FINANCING COST
Conclusion
• Financial flexibility is the ability of a firm to strategically use debt
financing to increase returns to investments by common shareholders.
• An alternative decomposition of ROCE requires the reformulation of
Financial Statements into operating and financing components, which
highlights the benefits available to common shareholders through
strategic use of leverage
• Firms with large spreads (Return on Net Operating Assets – The Net After-
Tax Borrowing Rate) stand to benefit from leverage
• The analysis of financial flexibility provides a natural link between
profitability analysis discusses previously and the analysis of numerous
risk.
Analyzing Short-Term Liquidity Risk
• Short-term liquidity is the firm’s ability to satisfy near-term payment
obligations to suppliers, employees, and creditors for short-term
borrowings, the current portion of long-tern debt, and other short-term
liabilities.
• Before analyzing, an analyst must understand the operating cycle of a
firm. Consider a typical manufacturing firm acquires raw materials, labor,
and other inputs to produce a product. It pays the cost at the time of
incurrence and promise to pay within 30 – 60 days.
• If a firms can delay all cash outflows to suppliers, employees, and others
until it receives cash from customers, and receives more cash than it must
disburse, the firm will not likely encounter short-term liquidity problems
Analyzing Short-Term Liquidity Risk …
cont’d
• In practice, a firm can satisfy short-term financial needs, firms often use long-
term leverage can trigger short-term liquidity problems. A firm may assume a
relatively high percentage of long-term debt in its capital structure that requires
periodic interest payments and may also require repayments of principal. For
some firms in financial, real estate, and energy industry, interest expense is
among the largest single cost. So, the operating cycle must generate sufficient
cash not only to provide for working capital need, but also service debt.
• Financially healthy firms frequently bridge temporary cash flow gaps in their
operating cash cycle with short-term borrowing with issuing commercial paper
(example)
• It is important to note available but untapped borrowing capacity when
assessing the overall financial risk profile of a firm.
Analyzing Short-Term Liquidity Risk …
cont’d
• A simple way to quickly grasp short-term liquidity issues is to examine
common size balance sheet.
• Financial ratios that been used for assessing short-term liquidity-risk:
• Current Ratio
• Quick Ratio
• Operating Cash Flow to Current Liabilities Ratio
• Account Receivable Turnover
• Inventory Turnover
• Accounts Payable Turnover
 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑙𝑖𝑡𝑖𝑒𝑠

Current Ratio
Current ratio should not be evaluated in isolation
and should be assessed in the context of other
factors, such as the length of the firms operating
cycle, the expected cash flow from operations,
the extent to which the firms has non-current
assets that could be used to for liquidify if
necessary
 Quick Ratio
• The Quick Ratio requires a similar contextual interpretation as the
current Ratio
• Interpretation of Quick Ratio including the firm’s ability to generate
cash flows from operations

𝑪𝒂𝒔𝒉 𝒂𝒏𝒅 𝑪𝒂𝒔𝒉 𝑬𝒒𝒖𝒊𝒗𝒂𝒍𝒆𝒏𝒕𝒔 +𝑺𝒉𝒐𝒓𝒕 𝑻𝒆𝒓𝒎 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕𝒔 + 𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆

𝑸𝒖𝒊𝒄𝒌 𝑹𝒂𝒕𝒊𝒐=
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
 • The indicator of the firm’s ability to generate
cash in the near term

Operating
Cash Flow to
Current
Liabilities
Working Capital Turnover Ratios
• Accounts Receivable Turnover =
• Inventory Turnover
• Accounts Payable Turnover

• These ratios are used as measure of the speed with which firms sell inventories and turn
accounts receivable into cash.
 The Cash-to-Cash Cycle

Days of Working Capital Financing Required

Days Inventory Held Days Accounts Receivable Outstanding

Days of Working Capital Financing Provided

Days of Working Capital Financing Needed from Other Sources

Days Account Payable Outstanding
 • Short-term liquidity risk ratios are helpful in
assessing a firm’s near-term ability to meet
cash flow requirements
• Analysis of profitability and cash flow levels
is an integral part of understanding short-
Conclusion term liquidity risk
• Profitable firms that generate significant
cash flows are characterized as having
financial flexibility, and such firms often
credit agreements with banks that further
enhance financial flexibility
Analyzing Long-Term Solvency Risk
• Financial leverage enhances ROCE when firms borrow funds and
invest those funds in assets that generate a higher than after-tax cost
of borrowing
• Measures for long-terms solvency risk:
• Debt Ratios
• Interest Coverage Ratios
• Operating Cash Flow to Total Liabilities Ratio
Debt Ratios
• Debt ratios measures the relative amount liabilities in a firm’s capital
structure.
Interest Coverage Ratios
• Interest coverage ratios indicates the number of times a firm’s income
or cash flows could cover interest charges
Operating Cash Flow to Total Liabilities
Ratio

𝑪𝒂𝒔𝒉𝑭𝒍𝒐𝒘 𝒇𝒓𝒐𝒎𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈𝑪𝒂𝒔𝒉𝑭𝒍𝒐𝒘𝒕𝒐𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑹𝒂𝒕𝒊𝒐=
𝑨𝒗𝒆𝒓𝒂𝒈𝒆𝑻𝒐𝒕𝒂𝒍 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Conclusion
• Debt, interest coverage, and cash flow ratios measure long-term
solvency risk
• Profitability and cash flows are indicators of the ability of a firm to
service its debt
• In addition to levels, trends are important for monitoring solvency risk
• A sharp drop in financial flexibility could be an early indicator of
potential liquidity and solvency problems
Analyzing Credit Risk
Factors that Affect Credit Risk
• Circumstances leading to the need for the loan
• Credit history
• Cash flows
• Assets that may be used as collateral
• Capacity for debt
• Contingencies
• Character of management
• Communication
• Conditions or covenants
 • The analysis of credit risk is a specialized form of financial
statement analysis
• The financial statements and notes provide evidence of a
firms
• Cash-generating ability
• Extent of collateralized assets
• Amount of unused debt capacity
• Constraints imposed by existing borrowing
agreements
Conclusion • Although financial statements might provide some clues,
you must search other sources for information on:
• Credit history of the borrower
• Market value of collateral
• Contingencies confronting the firm
• Character of management
• Existing lenders monitor a firm/s credit risk on an ongoing
basis
Analyzing Bankruptcy Risk

Indonesian Cases where firms filing for bankruptcy and delay payment(2022)

• PT Sentul City Tbk (BKSL)

• PT Hanson International Tbk (MYRX)
• PT Global Mediakom Tbk (BMTR)
• PT Ace Hardware Indonesia Tbk (ACES)

International Cases where firms filing for bankruptcy (2022)

• Rite Aid
• Bed Bath and Beyond
• Lordstown Motor
• SmileDirectClub
Models of Bankruptcy Prediction
• William Beaver (1960s) using 6 financial ratios to predict bankruptcy:
• Net Income plus Depreciation, Depletion, and amortization / Total Liabilities (long-
term solvency risk)
• Net Income / Total Assets (profitability)
• Total Debts / Total Assets (long-term solvency risk)
• Net Working Capital / Total Assets (short-term liquidity risk)
• Current Assets / Current Liabilities (short-term liquidity risk)
• Cash, Marketable Securities, Accounts Receivable / Operating Expenses excluding
Depreciation, Depletion, and Amortization (short-term liquidity risk)
Multiple Discriminant Analysis
• Late 1960’s and 1970s, researcher matched a sample of bankrupt
firms with healthy firms who had the same size in the same industry.
This matching procedures helps to control factors for size and industry
so researcher can examine the impact of other factors that might
explain bankruptcy
• Altman’s Z-Score prediction model is the best known
Principal Strength using MDA

It incorporates multiple financial ratios

simultaneously
It provides the appropriate coefficients for
combining the independent variables
It is easy to apply once the initial model has been
developed
Principal Criticism of MDA
• The researcher cannot be sure that MDA model includes all relevant discriminating
financial ratios
• The researcher must subjectively judge the value of the cutoff score that best
distinguishes bankrupt from non bankrupt firms
• The development and application of the MDA model requires firms to disclose the
information needed to compute each financial ratios.
• MDA assumes that each of the financial ratios from bankrupt and non bankrupt firms is
normally distributed.
• MDA requires that the variance and covariance matrix of the explanatory variables are
the same between bankrupt and non bankrupt firms
Bankruptcy Prediction Models using Logit
Analysis
• During 1980s and early 1990s, researcher using logit analysis because logit does not
require the data display the underlying statistical properties described previously for
MDA
• Procedure of logit analysis
• Initial calculation of large set of financial ratios
• Reduction of the set financial ratios to a subset that best predicts bankrupt and non
bankrupt firms
• Estimation of the coefficient for each included variable
Synthesis of Bankruptcy
Prediction Research
• Investment factors
• Financing factors
• Operating factors
• Other possible explanatory variables
• Cash flows
• Size
• Growth
• Qualified audit opinion
 • Recession
• Inflation
• Changes in interest rates
• Foreign currency fluctuations
Systematic Risk • Rising unemployment
Capital Asset Pricing Model
• CAPM as the basis for an individual firm’s risk-based required rate of return

• Beta (𝜷) is a measure of the systematic (or undiversifiable) risk of the firm.
The market through the pricing of a firm’s shares, rewards shareholders for
bearing systematic risk
• The 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 = 1, shows the firm experience covariability of returns equal to
the average covariability of the stock market
• Beta > 1, shows the firm experience covariability of returns greater
than the average covariability of the stock market
• Beta < 1, shows the firm experience covariability of returns less than
the average covariability of the stock market
Several firm-specific factors intuitively
related to a firm’s market beta
• Operating leverage
• Financial leverage
• Variability of sales