It is to determine risk from the balance sheet

Presented by:Priscilla Wong (97001051)Carmen Wong (97001303)

Carly Wong (97006010)

OutlineWhat is Balance Sheet?Use of Balance SheetWhat is risk?Types of risk we would talk aboutPossibility to determine risk from Balance SheetConclusionSources to determine risk

Balance SheetFinancial statement of positionList of all assets, liability & owner’s equityA single date, not a period of timeOne of the main documents legally required to be produced by companies as part of the annual report

Use of Balance SheetProvide information to assess the financial position at a particular point in timeSummarize information in a clear & intelligible formClassify items in an appropriate manner to show the strength of the enterpriseIndicate relative liquidity of assets & liabilityEvaluate financial position at a particular point of time

Question of Balance Sheet

Is it information in Balance Sheet useful to investor and other users?

Investors concernRational investors must consider:

expected return expected risk

for a given level of expected return, an investor will seek to minimize risk for a given level of expected risk, an investor will seek to maximize return

Expected ReturnIt can be obtained from the financial statement easily

For example, net income can be obtained from balance sheet from the change in retained earning

Expected RiskBut

Balance Sheet does not reflect any risk information directly

Risk“ Risk & financial reporting: A summary of the

discussion at the 1997 AAA/FASB conference” Risk is difficult to define because different financial users value information about different types of riskProbability that events will differ from what has predicted

risk is unforeseen Risk is difficult to assess due to uncertainty

Types of Risk

Business Risk (external)Operating Risk (internal)

Financial Risk (numerical)

Business Risk

Risk related to the company’s industryExternal to the business entity itselfInfluence on the entityNature of the business

Business RiskTechnology faced by the companyAvailability of product substitutesLevel of domestic and international involvementRobustness of demand for productsOverall diversification policyCapital/labour mixture

Business RiskRelations with trade unionsSize and wealthReputation of name and productExtent and nature of government interventionNature of legislation facedImpact on the physical environment Growth

Business RiskDifficult to quantifySubjective to each personRisk on the other hand may be chance

Help development of business in the futureNot appear in Balance Sheet

can’t be measured by Balance Sheet

Operating RiskRisk associated within the operation of the companyDifferent form the business risk Business risk related to the nature of the industryOperating risk related to the operation of that specified firm

Operating RiskFor example,

employee royalty turnover rate hinder operation recruit new people require time and

training sales and profit Risk

Operating Risk

If the major customer is lostFinancial difficulty may be resulted

We are encountering a financial problem… may go into liquidation…

Operating RiskOld production process

Ineffective for productionCost & fail to meet customer

demand on timeCustomer switch to other supplierSale and profitrisk

Operating RiskOperating activities of management related to the performance of the company directly change the investment decision of investors

However,Investors cannot obtain the operating information from the balance sheet easilyReason: information asymmetry

Operating RiskOperation risk is difficult to assess

Not enough information Difficult to quantify objectivelyUncertain about the time and amount of possible financial loss

Not easy to determine

Financial Risk

Risk imposed on the business by the use of debt finance (capital structure)

Related to the numerical data

Financial RiskConsider the capitalization structure

Ability to service existing structureSufficient profits to protect debt covenant violationSufficient cash to pay interest when due and dividend

Ability to maintain or alter present structure

Maintain present dividend policyIssue new securities

Financial RiskNumber itself may not reflect risk directlyMeasured by:

financial ratiostrend analysis

Financial RatioCurrent ratio = current assets/current liabilities

Quick ratio= (current assets –inventory)/current liabilities

The lower of current ratio & quick ratio financial risk not enough liquid asset to meet the debt

obligation

Financial Risk

Total debt ratio= total liabilities/total assets

The higher of total debt ratio financial risk the capital structure of firm is not so sound

Financial RatioDividend pay out ratio

= Dividend/Retained profitThe lower the dividend pay out ratio

financial risk not enough cash to pay out the

dividend

Financial RatioFinancial leverage

= total debt/total equityThe higher the gearing ratio financial risk use too much debt to finance its

operation pay huge amount of interest may not able to repay the debt

Financial RatioHowever…Short-term debt finance long term assets?Current assets really convertible into cash?Ratios calculated as on the balance sheet date timely to show the financial situation of the company now?

Problem of interpretation as income statement information is not taken into account

Trend AnalysisTechnique used for time periods in excess of 2 or more years Make results easier to understand and interpretProjection of the accounting figures indicate the risk faced by the company

Trend AnalysisImpacts of changes in technology on price of assets not reflectedSome assets depreciates faster, e.g. computersBut, consistent depreciation policy is appliedUndervaluation of assets

Risk associated with technology changes

can’t be assessed through balance sheet!!

Trend AnalysisImpacts of industry environment not reflected in Balance SheetBalance sheet reflects information of one company, not whole industrySuperior performance may not be due to good performance of that company, but due to the good performance of the whole industry

Trend Analysis

Accounting policies not applied consistentlyComparison not availableInterpretation misleading

Trend AnalysisFinancial information across companies within same industryDifferent company different size, different risks, different accounting policies comparison meaningless risk wrongly assessed

ConclusionRisk is very difficult to measure from Balance Sheet only because:

Balance sheet does not have sufficient information to measure risk

Balance sheet show a particular point of time only

Bias More complete risk measurement together with income statement and cash flow statement for financial risk

ConclusionNot every risk can be quantified objectivelyRisk full of uncertainty

When and how much the risk would happen

Difficult to determine risk

Determination of risk from Balance Sheet

Sources to Determine RiskGovernment Statistics

overall economic situation & industry situationTrade journals

the general situation of the overall industry

Growing? Declining?

More understanding on the industry assists more

accurate risk determination.

Sources to Determine RiskAnnual reportIncome statement & Cash flow statement & Balance Sheet:Financial informationOverall performanceprediction of future risk more accurately

Sources to Determine RiskAnnual report:Chairman’s StatementDirector’s report

the forthcoming challenges the firm is ready to face

company’s confidence towards the challenges

Sources to Determine RiskManagement behaviourchange in dividend policyE.g. Sudden drop in common dividend to zeroFailure to cover preferred dividends company short of cash