Risk Analysis: An Extended Look

1
Risk Analysis An Extended Look

• Dr. Nancy Mangold
• California State University, East Bay

2
Credit Risk

• A firms ability to make interest and principal
  payments on borrowings

3
Bankruptcy Risk

• The likelihood that a firm will file for
  bankruptcy and perhaps subsequently liquidate

4
Financial distress continuum

• Failing to make a required interest payment on
  time
• defaulting on a principal payment on debt
• filing for bankruptcy
• liquidating a firm

5
Financial Distress

• Analysts concerned with the economic loss of a
  portion or all of the amount lent to or invested
  in a firm can examine a firms position on this
  financial distress continuum.

6
Broader definition of risk

• To explain the differences in market rates of
  return of common stocks
• Economic theory holds that the differences in
  market return must relate to differences in
  perceived risk

7
Risk measure Market equity beta

• Market equity beta used as the measure of risk
• Market equity beta measures the covariability of
  a firms returns with the returns of all
  securities in the market

8
Sources of Debt FinancingCommercial Banks

• Commercial banks lend funds to firms to finance
• working capital needs
• accounts receivable
• inventory
• Accounts receivable and inventory serve as
  collateral
• Usually short-term less than one year
• Appear in Current liabilities - notes payable

9
Sources of Debt FinancingCommercial Banks

• Commercial banks also provide funds to purchase
  equipment, buildings, and other long-term assets
• These loans extend for periods of 20 or more
  years
• Specific assets financed used as a collateral
• appear in the long-term debt payable category

10
Sources of Debt FinancingOther Financial
Institutions

• Firms may also obtain funds from
• Insurance companies
• finance companies
• other financial institutions
• Finance long-term assets
• Assets serve as collateral for the borrowing

11
Sources of Debt FinancingCommercial paper Market

• Firms issue commercial paper for very short-term
  needs for cash
• meet payroll before collecting cash from accounts
  receivable monthly
• Unsecured
• Included in notes payable- current liabilities

12
Sources of Debt FinancingCommercial paper Market

• Large established firms with solid credit status
  most easily access the commercial paper market
  for funds
• Lenders in the commercial paper
• financial institutions
• business enterprises with excess cash
• money market mutual funds

13
Sources of Debt FinancingUnsecured Debt Market

• Firms needing long-term sources of funds can
  issue bonds on the open market
• Bonds are unsecured
• Priced according to
• the overall credit quality of the issuer
• the term to maturity of the bonds
• the general level of interest rates in the market

14
Sources of Debt FinancingUnsecured Debt Market

• In Bankruptcy
• First secured (collateralized lenders
• second bonds holders
• third preferred stockholdrs
• last common stockholders
• Long term debt payable on balance sheet
• investors financial institutions, mutual funds,
  pension funds and individuals

15
Sources of Debt FinancingSuppliers

• Suppliers of various goods and services that do
  not require firms to pay immediately implicitly
  provide funds to the firm
• Suppliers of raw materials or merchandise
  inventories may require that the inventories
  serve as collateral for the delayed payment

16
Credit Risk Analysis

• Circumstances leading to need for the loan
• Cash Flows
• Collateral
• Capacity for Debt
• Contingencies
• Character of Management
• Conditions

17
Circumstances leading to need for the loan

• The reason that a firm needs to borrow affects
  the riskiness of the loan and the likelihood of
  repayment

18
W.T. Grant Company

• Discount retail chain filed for bankruptcy in
  1975
• Between 1968 and 1975 Grant experienced
  increasing difficulty collecting accounts
  receivables.
• Borrow short-term funds from commercial banks to
  finance the buildup of its accounts receivable

19
W.T. Grant Company

• Lending to satisfy cash flow needs related to an
  unsolved problem or difficulty can be highly risky

20
Toys R Us

• Purchases toys, games, and other entertainment
  products in September and October in anticipation
  of heavy demand during the end-of-the year
  holiday season
• Typically pays its suppliers within 30 days for
  these purchases, but doesnt collect cash from
  customers until December, January or later

21
Toys R Us

• Borrow short term funds from its banks to finance
  its inventory
• Repays these loans with cash collected from
  customers
• Lending to satisfy cash flow needs related to
  ongoing seasonal business operations is generally
  relatively low risk
• Toys R Us has an established brand name and
  predictable demand and diverse product line

22
Wal-Mart Stores

• Grows the number of its stores at a rate of 12
  per year during the last five years
• The fastest growth is in its superstores ( a
  combination of its traditional discount store and
  a grocery store).
• Borrows a large portion of the funds needed to
  construct new stores using 20- to 25-year loans

23
Wal-Mart Stores

• Also enters into leases for a significant portion
  of the space needed for its new stores
• Such loans are relatively low risk
• given Wal-Marts operating success in the past
• the land and buildings that serve as collateral
  for the loans

24
Data General Corporation

• mMaintained a presence in the midsize computer
  market for several decades
• Technological advances and aggressive marketing
  by competitors have eroded its share of the
  computer market .

25
Data General Corporation

• Wanted to develop new technologies for internet
  products
• Needed to borrow funds to finance its research
  and development effort

26
Data General Corporation

• Such a loan would be relatively high-risk
• embarking on a new line of business for which it
  does not necessarily have a competitive advantage
• rapid technology change
• RD expenditures may not result in assets that
  can be serve as collateral for the loan

27
Lower credit risk

• Lending to established firms for ongoing
  operating needs

28
Higher credit risks

• Lending to firms experiencing operating problems
• Lending to emerging businesses
• Lending to support investments in intangible
  assets typically carry higher risks

29
Cash Flows

• Lenders want firms to generate sufficient cash
  flow to pay interest and repay principal on a
  loan so they dont have to rely on selling the
  collateral

30
Cash Flows

• Tools for studying the cash-generating ability of
  a firm
• examination of the statement of cash flows for
  recent years
• computation of various cash flow-based financial
  ratios
• study of projected financial statements

31
Statement of Cash Flows

• Indicators of potential cash flow problems if
  observed for several years in a row
• Growth in accounts receivable or inventories that
  exceeds the growth rate in sales
• Increases in accounts payable that exceed the
  increase in inventories

32
Indicators of potential cash flow problems

• Other current liabilities that grow at a faster
  rate than sales
• Persistent negative cash flow from operations
  because of net losses or substantial increases in
  net working capital

33
Indicators of potential cash flow problems

• Capital expenditures that substantially exceed
  cash flow from operations
• indicates a firms continuing need for external
  financing to sustain growth
• Reductions in capital expenditures over time
• signal declines in future sales, earnings, and
  operating cash flows

34
Indicators of potential cash flow problems

• Sales of marketable securities in excess of
  purchases of marketable securities
• signal the inability of a firms operations to
  provide adequate cash flow to finance working
  capital and long-term investments

35
Indicators of potential cash flow problems

• A substantial shift from long-term borrowing to
  short-term borrowing
• signal a firms inability to obtain long-term
  loans because lenders are uncertain about a
  firms future
• A reduction or elimination of dividend payments
• a negative signal about a firms future prospects

36
Cash Flow Financial Ratios

• Cash Flow from operations
• Average Current liabilities
• Indicates the ability of a firm to generate
  sufficient cash flows from operations to repay
  liabilities coming due with the next year

37
Cash Flow Financial Ratios

• Cash flow from operations
• Average Total Liabilities
• Indicates a firms ability to generate sufficient
  cash flow to repay all liabilities

38
Cash Flow Financial Ratios

• Cash flow from operations
• Capital Expenditures
• Indicates the ability of a firm to finance
  capital expenditures with operating cash flows
• lt1 indicates a will need to continue to find
  various sources of capital to finance capital
  expenditures to continue its growth

39
Projected Financial Statements

• Projected financial statements , Pro Forma
  financial statements represent forecasted income
  statements, balance sheets, and statements of
  cash flows for some number of years into the
  future
• Lenders require potential borrowers to prepare
  such statements to demonstrate the borrowers
  ability to repay the loan with interest as it
  comes due

40
Projected Financial Statements

• The credit analyst should question each of the
  important assumptions underlying these projected
  financial statements
• sales growth
• cost structure
• capital expenditure plans
• Should also assess the sensitivity of the
  projected cash flows to change sin key assumptions

41
Collateral

• The availability and value of collateral for a
  loan
• If cash flows are insufficient to pay interest
  and repay the principal on a loan, the lender has
  the right to obtain any collateral pledged in
  support of the loan

42
Collateral

• Marketable Securities reported at at market value
  on balance sheet (lt 20 ownership)
• Assess whether the market value of securities
  pledged as collateral exceeds the unpaid balance
  of a loan

43
Collateral

• Accounts Receivable
• Assess whether the current value of accounts
  receivable is sufficient to cover the unpaid
  portion of a loan collateralized by accounts
  receivable

44
Collateral

• Examine
• changes in provision for uncollectible accounts
  relative to sales
• the balance in allowance for uncollectible
  accounts relative to gross accounts receivable
• the amount of accounts written off as
  uncollectible relative to gross accounts
  receivable
• the number of days receivables are outstanding

45
Inventories

• Examine
• Changes in inventory turnover rate
• Cost of goods sold to sales percentage
• Mix of raw materials, work in process
  inventories, and finished goods inventories to
  identify possible inventory obsolescence problems

46
Inventories

• LIFO inventories market value exceed the book
  value
• FIFO inventories will be closer to market value
• Using footnotes on the excess of market or FIFO
  value over LIFO cost permit the analyst to assess
  the adequacy of LIFO inventories to cover the
  unpaid balance on a loan collateralized by
  inventories

47
Property, Plant and Equipment

• Fixed assets as collateral for long-term
  borrowing
• Determining the market values of such assets is
  difficult using reported financial statement
  information because the use of historical cost
  valuations
• Market values of unique, firm-specific assets are
  particularly difficult to ascertain.

48
Property, Plant and Equipment

• Clues indicating market value declines include
• restructuring charges
• asset impairment charges related to such assets
• recent sales at a loss

49
Nonsecured lending

• Study the notes to the financial statements to
  ascertain how much of the borrowers assets are
  not already pledged or restricted
• The liquidation value of such assets represents
  the available resources of a firm to repay
  unsecured creditors

50
Nonsecured lending

• For small business, additional source of
  collateral may be
• personal assets of management or major
  shareholders

51
Capacity for Debt

• A firms capacity to assume additional debt
• A firms cash flows and collateral represent the
  means to repay the debt
• Most firms do not borrow up to the limit of their
  debt capacity
• Lenders want to make sure that a margin of safety
  exists

52
Capacity for DebtDebt Ratios

• long-term debt ( total liabilities )
• / total assets
• long-term debt ( total liabilities )
  /shareholders equity
• consider off-balance sheet obligations
• operating lease commitments
• underfunded pension
• health care benefit obligation

53
Capacity for DebtDebt Ratios

• The higher the debt ratios
• The higher the credit risk
• The lower the unused debt capacity of the firm

54
Capacity for DebtInterest Coverage Ratio

• Operating income before interest and taxes /
  interest payments
• A measure of margin of safety provided by
  operations to service debt

55
Capacity for DebtInterest Coverage Ratio

• When firms make heavy use of operating leases for
  their fixed assets, the analyst might convert the
  operating leases to capital leases for the
  purpose of computing the interest coverage ratio
• add back the lease payments to net income
• include the lease payments in the denominator

56
Capacity for DebtInterest Coverage Ratio

• lt2 high credit risk
• gt 4 capacity to carry additional debt

57
Contingencies

• Is the firm a defendant in a major lawsuit
  involving its principal products
• Negative legal judgments will likely have a more
  pronounced effect on smaller firms
• less resource to defend themselves
• less resource to sustain such losses
• may not carry adequate insurance

58
Contingencies

• Has the firm served as guarantor on a loan by a
  subsidiary, joint venture, or corporate officer

59
Contingencies

• Has the firm committed itself to make payments
  related to derivative financial instruments that
  could adversely affect future cash flows if
  interest rate, exchange rates or other prices
  change significantly in an unexpected direction?

60
Contingencies

• Is the firm dependent on one or a few
• key employees,
• contracts
• license agreements, or
• technologies
• whose loss could substantially affect the
  viability of the business?

61
Contingencies

• Examine notes to the financial statements
• Ask questions of management, attorneys and
  others.

62
Character of Management

• Has the management team successfully weathered
  previous operating problems and challenges that
  could have bankrupted most firms?

63
Character of Management

• Has the management team delivered in the past on
  projections made with regard to
• sales level
• cost reductions
• new product development
• other operating targets

64
Character of Management

• Does the firm have a reputation for honest and
  fair dealings with suppliers, customers, bankers,
  and others?
• Do managers have a substantial portion of their
  personal wealth invested in the firms common
  equity
• managers have incentives to operate the firm
  profitably and avoid defaulting on debt to
  increse the value of their equity holding

65
Conditions

• Lenders often place restrictions or constraints
  on a firm to protect their interests
• Minimum level of certain financial ratios
  (current ratio gt 1.2))
• maximum level of certain financial ratios
  (debt/equity ratio lt 75)
• Restrictions on paying dividends
• Limit on new financing

66
Conditions

• Debt covenants can protect the interest of
  senior, collateralized lenders
• protection again undue deterioration in the
  financial condition of a firm
• They can place less senior lenders in jeopardy if
  the firm must quickly liquidate assets to repay
  debt
• increase the likelihood of default or bankruptcy
  if the constraints are too tight

67
The Bankruptcy Process

• firms may file under Chapter XI of the National
  Bankruptcy Code
• Firms have four months to present a plan of
  reorganization to the court
• After four months, creditors, employees and
  others can file their plans of reorganization

68
The Bankruptcy Process

• The court decides which plan provides the fairest
  treatment for all parties concerned
• When the court determines that the firm has
  executed the plan of reorganization successfully
  and appears to be viable entity, the firm is
  released from bankruptcy

69
The Bankruptcy Process

• A Chapter XII filing for bankruptcy entails an
  immediate sale or liquidation of the firms
  assets and a distribution of the proceeds to the
  various claimants in the order of their priority.

70
Models of Bankruptcy Prediction

• Univariate Bankruptcy Prediction Models examine
  the relation between a particular financial
  statement ratio and bankruptcy

71
Univariate Bankruptcy Prediction Models

• Beaver studied 29 financial statement ratios for
  the five years preceding bankruptcy for a sample
  of bankrupt and non-bankrupt firms

72
Univariate Bankruptcy Prediction Models

• The six ratios with the best discriminating power
  are
• (long-term solvency risk
• NI before depreciation, depletion and
  amortization/ Total Liabilities
• Profitability
• NI/Total Assets

73
Univariate Bankruptcy Prediction Models

• Long-term solvency risk
• Total Debt/ Total Assets
• Short-term liquidity 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

74
Multivariate Bankruptcy Prediction Models

• Multiple Discriminant Analysis (MDA)
• The best-known MDA bankruptcy prediction model is
  Altmans Z-score

75
Altmans Bankruptcy Prediction Model

• Z 1.2(NWC/TA) 1.4(RE/TA) 3.3(EBIT/TA)
  .6(MV-EQ/BV-Liab) 1.0(S/TA)
• MWC/TA1(current assets - current
  liabilities)/total assets
• measure the proportion of total assets
  representing relatively liquid net current assets
  (ST liquidity risk)

76
Altmans Bankruptcy Prediction Model

• RE/TA retained earnings / total assets
• measures accumulated profitability and relative
  age of a firm
• EBIT/TA EBIT / total assets
• measures current profitability

77
Altmans Bankruptcy Prediction Model

• MV-EQ/BV-Liab market value of preferred and
  common equity / book value of total liabilities
• markets overall assessment of the profitability
  and risk of the firm
• S/TA sales / total assets
• measures ability of a firm to use assets to
  generate sales

78
Altmans Bankruptcy Prediction Model

• If Z gt 2.99 assign to nonbankrupt group, low
  probability of bankruptcy
• If Z lt 1.81 assign to bankrupt group, higher
  probability of bankruptcy
• 1.81 lt Z lt 2.99 gray area

79
Multivariate Bankruptcy Prediction Models

• James Ohlson used Logit Analysis to discriminate
  bankrupt from non-bankrupt firms
• y-1.32 - 0.407(SIZE) 6.03(TLTA) - 1.43(WCTA)
  0.0757(CLCA) - 2.37)NITA) -
• 1.83 (FUTL) 0.285 (INTWO) - 1.72 (OENEG) -
  0.521 (CHIN)

80
Multivariate Bankruptcy ModelLogit Analysis

• Size larger firms have greater flexibility to
  curtail capacity, sell assets, and attract debt
  or equity capital than smaller firms
• TLTA (Total Liabilities/ Total Assets)
• Long-term solvency risk
• Higher debt ratios increase the probability of
  bankruptcy

81
Multivariate Bankruptcy ModelLogit Analysis

• WCTA (Working capital/Total Assets
• the higher the proportion of net working capital
  to total assets,
• the more liquid are the assets
• the lower the probability of bankruptcy

82
Multivariate Bankruptcy ModelLogit Analysis

• CLCA (Current Liabilities/Current Assets)
• An excess of current liabilities over current
  assets is also an indicator of short-term
  liquidity risk

83
Multivariate Bankruptcy ModelLogit Analysis

• NITA (Net Income/Total Assets)
• the higher the rate of profitability,
• the less likely a firm will experience difficulty
  servicing debt
• the lower the probability of bankrupty

84
Multivariate Bankruptcy ModelLogit Analysis

• FUTL (Funds (Working capital) from operations/
  Total Liabilities)
• the greater the ability of working capital from
  operations to cover total liabilities
• the lower the probability of bankruptcy

85
Multivariate Bankruptcy ModelLogit Analysis

• INTWO (one if net income was negative for the
  last two years and 0 otherwise)
• A recent history of net losses increases the
  probability of bankruptcy

86
Multivariate Bankruptcy ModelLogit Analysis

• OENEG (One if total liabilities exceed total
  assets and zero otherwise)
• appears redundant with TLTA
• coefficient should be positive but is negative

87
Multivariate Bankruptcy ModelLogit Analysis

• CHIN (Net income (t) - Net Income (t-1))/(INet
  Income (t)I Inet Income (t-1)I
• The change in net income indicates the direction
  and magnitude of earnings growth or decline.
• Increasing (decreasing) earnings coupled with the
  negative coefficient suggest a lower (higher)
  probability of bankrupty

88
Synthesis of Bankruptcy Prediction Research

• Investment Factors
• Relative Liquidity of a Firms Assets
• Rate of Asset Turnover

89
Relative Liquidity of a Firms Assets

• Firms with relatively large proportions of
  current assets tend to experience less financial
  distress than firms whose dominant assets are
  fixed assets or intangible assets
• Expected return on the more liquid assets is
  usually less than the expected return from fixed
  and intangible assets reflecting its lower risk

90
Relative Liquidity of a Firms Assets

• Firms must balance their mix of assets to obtain
  the desired return/risk profile
• Ratios include
• Cash/Total assets
• Current assets/total assets
• net working capital/total assets

91
Rate of Asset Turnover

• The more quickly assets turn over, the more
  quickly funds work their way toward cash on the
  balance sheet
• Retailer has same fixed assets to total assets as
  a manufacturing firm, but higher turnover ratios
  thus more liquid.

92
Rate of Asset Turnover

• Ratios include
• total assets turnover
• accounts receivable turnover
• inventory turnover
• the working capital turnover
• fixed asset turnover

93
Financing Factors

• Relative Proportion of Debt in the Capital
  Structure
• the higher the proportion of liabilities in the
  capital structure
• the higher the probability that firms will
  experience bankruptcy
• Firms with lower levels of debt tend to have
  unused borrowing capacity that they can depend on
  in times of difficulty

94
Financing Factors

• Relative Proportion of Short-Term Debt in the
  Capital Structure
• The more imminent due dates of debt exacerbate
  the risk of bankruptcy
• Ratio include
• Current liabilities/total assets

95
Operating Factors

• Relative Level of Profitability
• Profitable firms ultimately turn their earnings
  into cash
• Firms with low or negative profitability must
  often rely on available cash or additional
  borrowing to meet financial commitments as they
  come due
• Weak profitability and high debt ratios usually
  spells financial distress

96
Operating Factors

• Profitability ratios
• net income/assets
• income before interest and taxes/assets
• net income/sales
• cash flow from operations/assets

97
Operating Factors

• Variability of Operations
• Firms that experience variability in their
  operations (cyclical sales patterns) are more in
  danger of bankruptcy than firms with less
  variability
• measure
• change in sales
• change in net income from the previous year

98
Other Possible Explanatory Variables

• Size
• Larger firms generally have access to a wider
  range of financing sources as well as more
  flexibility to redeploy assets than smaller firms
• Larger firms are less subject to bankruptcy than
  smaller firms

99
Other Possible Explanatory Variables

• Growth
• Rapidly growing firms often need external
  financing to cover cash shortfalls from
  operations and permit acquisitions of fixed
  assets
• they display high debt ratios and weak
  profitability
• But their growth potential provides access to
  capital that permits to survive

100
Other Possible Explanatory Variables

• Qualified Audit Opinion
• has much the same predictive accuracy as the
  models based on financial ratios

101
Market Risk

• Economic theory teaches that differences in
  expected rates of return for different investment
  alternatives should relate to differences in risk

102
Market Rate of Return

• Return on common stock
• Risk Free interest rate Market beta ( market
  return - risk free interest rate)
• The beta coefficient measures the covariability
  of a firms returns with those of all shares
  traded on the market

103
Market Risk

• Beta captures the systematic risk
• The pricing of common stock rewards shareholders
  they assume
• An investor can eliminate nonsystematic risk by a
  diversified portfolio

104
Market Beta

• Three principal explanatory variables
• Degree of operating leverage
• Degree of financial leverage
• Variability of sales

105
Market Beta

• Firms with a market beta of 1 experience
  variability equal to the average
• Firms with a market beta of more than 1experience
  greater variability than the average
• Firms with a beta of less than 1 experience less
  variability than the average firm
• Exhibit 9.6

106
Utilities

• Have capital-intensive facilities and use
  extensive borrowing to finance their acquisition
• lowest assets turnover ratios
• highest capital structure leverage ratios
• ROCE is smallest of all the industries
• Their market beta is the smallest

107
Metals and Metal Products

• The metals industry takes iron ore and other
  minerals and processes them into steel and other
  intermediate products
• Capital intensive
• Products tend to portray commodity characteristics

108
Metals and Metal Products

• The metal products industry takes steel and other
  intermediate products and processes them into
  final products that have an element of
  differentiation
• less capital intensive
• faster asset turnover than the metals industry

109
Metals and Metal Products

• Similar capital structure leverage ratios
• ROCE is higher for the metal products segment -
  differentiated product
• Market beta of metal products is less than that
  for metals

110
Grocery Stores, Food Processors and Restaurants

• Less variability in the ROCE of grocery stores
  (.74) and food processors (.79) (demand is
  relatively price -inelastic) than restaurants
  (.90) where demand has greater price elasticity

111
Amusements and hotels

• Heavy investments in fixed assets and debt
• Economic conditions affect the demand for their
  products
• Amusement industry experienced much less
  variability in its ROCE than hotels
• The amusements industry is also less capital
  intensive and debt intensive than hotels
• Amusement (.74) smaller beta than Hotel (.95)

112
Printing and Publishing, Lumber, and Paper

• Paper industry is more capital-intensive and
  debt-intensive than the printing and publishing
  industry and the lumber industry
• Expect market beta for printing lower than lumber
  lower than paper industry
• But 3 market betas are similar (.88, .89, .89)

113
Petroleum

• Capital and debt intensive
• Std deviation of ROCE relatively high
• Market beta the smallest of 22 industries

114
Bankruptcy risk and Market Beta Risk

• High proportions of fixed assets in the asset
  structure provide relatively illiquid assets
  (increasing bankruptcy risk) and high fixed costs
  (increasing market beta risk).

115
Bankruptcy risk and Market Beta Risk

• High proportions of debt in the capital structure
  require regular debt servicing (increasing
  bankruptcy risk) and high fixed costs for
  interest (increasing market beta)

116
Bankruptcy risk and Market Beta Risk

• Variability of sales raises the possibility that
  a firm may not have sufficient liquid assets to
  service debt (increasing bankruptcy risk) and
  creates fluctuation in earnings (increasing
  market beta risk)

117
Bankruptcy risk and Market Beta Risk

• Bankruptcy risk relates primarily to an
  illiquidity problem
• Market beta risk relates more to an earnings
  problem
• Bankruptcy risk when it becomes important for a
  particular firm intensifies the underlying market
  beta risk