Risk Analysis: An Extended Look Dr. Nancy Mangold California State University, East Bay.

Risk Analysis: An Extended Risk Analysis: An Extended LookLook

Dr. Nancy MangoldDr. Nancy Mangold

California State University, California State University, East BayEast Bay

Credit RiskCredit Risk

A firm’s ability to make interest A firm’s ability to make interest and principal payments on and principal payments on borrowingsborrowings

Bankruptcy RiskBankruptcy Risk

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

Financial distress Financial distress continuumcontinuum

Failing to make a required interest Failing to make a required interest payment on timepayment on time

defaulting on a principal payment defaulting on a principal payment on debton debt

filing for bankruptcyfiling for bankruptcy liquidating a firmliquidating a firm

Financial DistressFinancial Distress

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

Broader definition of riskBroader definition of risk

To explain the differences in To explain the differences in market rates of return of common market rates of return of common stocksstocks

Economic theory holds that the Economic theory holds that the differences in market return must differences in market return must relate to differences in perceived relate to differences in perceived riskrisk

Risk measure :Risk measure :Market equity betaMarket equity beta

Market equity beta used as the Market equity beta used as the measure of riskmeasure of risk

Market equity beta measures the Market equity beta measures the covariability of a firm’s returns covariability of a firm’s returns with the returns of all securities in with the returns of all securities in the marketthe market

Sources of Debt Financing:Sources of Debt Financing:Commercial BanksCommercial Banks

Commercial banks lend funds to firms to Commercial banks lend funds to firms to financefinance• working capital needsworking capital needs• accounts receivableaccounts receivable• inventoryinventory

Accounts receivable and inventory serve Accounts receivable and inventory serve as collateralas collateral

Usually short-term: less than one yearUsually short-term: less than one year Appear in Current liabilities - notes payableAppear in Current liabilities - notes payable

Sources of Debt Financing:Sources of Debt Financing:Commercial BanksCommercial Banks

Commercial banks also provide funds to Commercial banks also provide funds to purchase equipment, buildings, and purchase equipment, buildings, and other long-term assetsother long-term assets

These loans extend for periods of 20 or These loans extend for periods of 20 or more yearsmore years

Specific assets financed used as a Specific assets financed used as a collateralcollateral

appear in the long-term debt payable appear in the long-term debt payable categorycategory

Sources of Debt Financing:Sources of Debt Financing:Other Financial InstitutionsOther Financial Institutions

Firms may also obtain funds fromFirms may also obtain funds from• Insurance companiesInsurance companies• finance companiesfinance companies• other financial institutionsother financial institutions

Finance long-term assetsFinance long-term assets Assets serve as collateral for the Assets serve as collateral for the

borrowingborrowing

Sources of Debt Financing:Sources of Debt Financing:Commercial paper MarketCommercial paper Market

Firms issue commercial paper for Firms issue commercial paper for very short-term needs for cashvery short-term needs for cash• meet payroll before collecting cash meet payroll before collecting cash

from accounts receivable monthly from accounts receivable monthly UnsecuredUnsecured Included in notes payable- current Included in notes payable- current

liabilitiesliabilities

Sources of Debt Financing:Sources of Debt Financing:Commercial paper MarketCommercial paper Market

Large established firms with solid Large established firms with solid credit status most easily access credit status most easily access the commercial paper market for the commercial paper market for fundsfunds

Lenders in the commercial paperLenders in the commercial paper• financial institutionsfinancial institutions• business enterprises with excess cashbusiness enterprises with excess cash• money market mutual fundsmoney market mutual funds

Sources of Debt Financing:Sources of Debt Financing:Unsecured Debt MarketUnsecured Debt Market

Firms needing long-term sources of Firms needing long-term sources of funds can issue bonds on the open funds can issue bonds on the open marketmarket

Bonds are unsecuredBonds are unsecured Priced according toPriced according to

• the overall credit quality of the issuerthe overall credit quality of the issuer• the term to maturity of the bondsthe term to maturity of the bonds• the general level of interest rates in the the general level of interest rates in the

marketmarket

Sources of Debt Financing:Sources of Debt Financing:Unsecured Debt MarketUnsecured Debt Market

In BankruptcyIn Bankruptcy• First: secured (collateralized lendersFirst: secured (collateralized lenders• second: bonds holders second: bonds holders • third: preferred stockholdrsthird: preferred stockholdrs• last: common stockholderslast: common stockholders

Long term debt payable on balance Long term debt payable on balance sheetsheet

investors: financial institutions, mutual investors: financial institutions, mutual funds, pension funds and individualsfunds, pension funds and individuals

Sources of Debt Financing:Sources of Debt Financing:SuppliersSuppliers

Suppliers of various goods and Suppliers of various goods and services that do not require firms to services that do not require firms to pay immediately implicitly provide pay immediately implicitly provide funds to the firmfunds to the firm

Suppliers of raw materials or Suppliers of raw materials or merchandise inventories may merchandise inventories may require that the inventories serve as require that the inventories serve as collateral for the delayed paymentcollateral for the delayed payment

Credit Risk AnalysisCredit Risk Analysis

Circumstances leading to need for the Circumstances leading to need for the loanloan

Cash FlowsCash Flows CollateralCollateral Capacity for DebtCapacity for Debt ContingenciesContingencies Character of ManagementCharacter of Management ConditionsConditions

Circumstances leading to Circumstances leading to need for the loanneed for the loan

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

W.T. Grant CompanyW.T. Grant Company

Discount retail chain filed for Discount retail chain filed for bankruptcy in 1975bankruptcy in 1975

Between 1968 and 1975 Grant Between 1968 and 1975 Grant experienced increasing difficulty experienced increasing difficulty collecting accounts receivables.collecting accounts receivables.

Borrow short-term funds from Borrow short-term funds from commercial banks to finance the commercial banks to finance the buildup of its accounts receivablebuildup of its accounts receivable

W.T. Grant CompanyW.T. Grant Company

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

Toys “R” Us Toys “R” Us

Purchases toys, games, and other Purchases toys, games, and other entertainment products in September entertainment products in September and October in anticipation of heavy and October in anticipation of heavy demand during the end-of-the year demand during the end-of-the year holiday seasonholiday season

Typically pays its suppliers within 30 Typically pays its suppliers within 30 days for these purchases, but doesn’t days for these purchases, but doesn’t collect cash from customers until collect cash from customers until December, January or laterDecember, January or later

Toys “R” UsToys “R” Us

Borrow short term funds from its banks to Borrow short term funds from its banks to finance its inventoryfinance its inventory

Repays these loans with cash collected from Repays these loans with cash collected from customerscustomers

Lending to satisfy cash flow needs related to Lending to satisfy cash flow needs related to ongoing seasonal business operations is ongoing seasonal business operations is generally relatively low riskgenerally relatively low risk

Toys “R” Us has an established brand name Toys “R” Us has an established brand name and predictable demand and diverse product and predictable demand and diverse product lineline

Wal-Mart StoresWal-Mart Stores

Grows the number of its stores at a rate Grows the number of its stores at a rate of 12% per year during the last five of 12% per year during the last five yearsyears

The fastest growth is in its superstores ( The fastest growth is in its superstores ( a combination of its traditional discount a combination of its traditional discount store and a grocery store).store and a grocery store).

Borrows a large portion of the funds Borrows a large portion of the funds needed to construct new stores using needed to construct new stores using 20- to 25-year loans20- to 25-year loans

Wal-Mart StoresWal-Mart Stores

Also enters into leases for a Also enters into leases for a significant portion of the space significant portion of the space needed for its new storesneeded for its new stores

Such loans are relatively low risk Such loans are relatively low risk • given Wal-Mart’s operating success in given Wal-Mart’s operating success in

the pastthe past• the land and buildings that serve as the land and buildings that serve as

collateral for the loanscollateral for the loans

Data General CorporationData General Corporation

mMaintained a presence in the mMaintained a presence in the midsize computer market for midsize computer market for several decadesseveral decades

Technological advances and Technological advances and aggressive marketing by aggressive marketing by competitors have eroded its share competitors have eroded its share of the computer market .of the computer market .


Wanted to develop new Wanted to develop new technologies for internet productstechnologies for internet products

Needed to borrow funds to finance Needed to borrow funds to finance its research and development its research and development efforteffort


Such a loan would be relatively Such a loan would be relatively high-riskhigh-risk• embarking on a new line of business embarking on a new line of business

for which it does not necessarily have for which it does not necessarily have a competitive advantagea competitive advantage

• rapid technology changerapid technology change• R&D expenditures may not result in R&D expenditures may not result in

assets that can be serve as collateral assets that can be serve as collateral for the loanfor the loan

Lower credit riskLower credit risk

Lending to established firms for Lending to established firms for ongoing operating needs ongoing operating needs

Higher credit risksHigher credit risks

Lending to firms experiencing Lending to firms experiencing operating problemsoperating problems

Lending to emerging businesses Lending to emerging businesses Lending to support investments in Lending to support investments in

intangible assets typically carry intangible assets typically carry higher riskshigher risks

Cash FlowsCash Flows

Lenders want firms to generate Lenders want firms to generate sufficient cash flow to pay interest sufficient cash flow to pay interest and repay principal on a loan so and repay principal on a loan so they don’t have to rely on selling they don’t have to rely on selling the collateralthe collateral

Cash FlowsCash Flows

Tools for studying the cash-Tools for studying the cash-generating ability of a firmgenerating ability of a firm• examination of the statement of cash examination of the statement of cash

flows for recent yearsflows for recent years• computation of various cash flow-computation of various cash flow-

based financial ratiosbased financial ratios• study of projected financial study of projected financial

statementsstatements

Statement of Cash FlowsStatement of Cash Flows

Indicators of potential cash flow Indicators of potential cash flow problems if observed for several problems if observed for several years in a rowyears in a row

Growth in accounts receivable or Growth in accounts receivable or inventories that exceeds the inventories that exceeds the growth rate in salesgrowth rate in sales

Increases in accounts payable that Increases in accounts payable that exceed the increase in inventoriesexceed the increase in inventories

Indicators of potential Indicators of potential cash flow problemscash flow problems

Other current liabilities that grow Other current liabilities that grow at a faster rate than salesat a faster rate than sales

Persistent negative cash flow from Persistent negative cash flow from operations because of net losses or operations because of net losses or substantial increases in net substantial increases in net working capitalworking capital


Capital expenditures that Capital expenditures that substantially exceed cash flow from substantially exceed cash flow from operationsoperations• indicates a firm’s continuing need for indicates a firm’s continuing need for

external financing to sustain growthexternal financing to sustain growth Reductions in capital expenditures Reductions in capital expenditures

over timeover time• signal declines in future sales, earnings, signal declines in future sales, earnings,

and operating cash flowsand operating cash flows


Sales of marketable securities in Sales of marketable securities in excess of purchases of marketable excess of purchases of marketable securitiessecurities• signal the inability of a firm’s signal the inability of a firm’s

operations to provide adequate cash operations to provide adequate cash flow to finance working capital and flow to finance working capital and long-term investmentslong-term investments


A substantial shift from long-term A substantial shift from long-term borrowing to short-term borrowingborrowing to short-term borrowing• signal a firm’s inability to obtain long-signal a firm’s inability to obtain long-

term loans because lenders are term loans because lenders are uncertain about a firm’s futureuncertain about a firm’s future

A reduction or elimination of dividend A reduction or elimination of dividend paymentspayments• a negative signal about a firm’s future a negative signal about a firm’s future

prospectsprospects

Cash Flow Financial RatiosCash Flow Financial Ratios

Cash Flow from operations Cash Flow from operations

Average Current liabilitiesAverage Current liabilities

Indicates the ability of a firm to Indicates the ability of a firm to generate sufficient cash flows from generate sufficient cash flows from operations to repay liabilities operations to repay liabilities coming due with the next yearcoming due with the next year


Cash flow from operationsCash flow from operations

Average Total LiabilitiesAverage Total Liabilities

IndicatesIndicates a firm’s ability to a firm’s ability to generate sufficient cash flow to generate sufficient cash flow to repay all liabilitiesrepay all liabilities


Cash flow from operations Cash flow from operations

Capital ExpendituresCapital Expenditures Indicates the ability of a firm to finance Indicates the ability of a firm to finance

capital expenditures with operating capital expenditures with operating cash flowscash flows

<1 indicates a will need to continue to <1 indicates a will need to continue to find various sources of capital to finance find various sources of capital to finance capital expenditures to continue its capital expenditures to continue its growthgrowth

Projected Financial Projected Financial StatementsStatements

Projected financial statements , Projected financial statements , Pro Pro Forma Forma financial statements represent financial statements represent forecasted income statements, balance forecasted income statements, balance sheets, and statements of cash flows for sheets, and statements of cash flows for some number of years into the futuresome number of years into the future

Lenders require potential borrowers to Lenders require potential borrowers to prepare such statements to demonstrate prepare such statements to demonstrate the borrower’s ability to repay the loan the borrower’s ability to repay the loan with interest as it comes duewith interest as it comes due

Projected Financial Projected Financial StatementsStatements

The credit analyst should question each The credit analyst should question each of the important assumptions underlying of the important assumptions underlying these projected financial statementsthese projected financial statements• sales growthsales growth• cost structurecost structure• capital expenditure planscapital expenditure plans

Should also assess the sensitivity of the Should also assess the sensitivity of the projected cash flows to change sin key projected cash flows to change sin key assumptionsassumptions

CollateralCollateral

The availability and value of The availability and value of collateral for a loancollateral for a loan

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


Marketable Securities reported at Marketable Securities reported at at market value on balance sheet at market value on balance sheet (< 20% ownership)(< 20% ownership)

Assess whether the market value Assess whether the market value of securities pledged as collateral of securities pledged as collateral exceeds the unpaid balance of a exceeds the unpaid balance of a loanloan


Accounts ReceivableAccounts Receivable Assess whether the current value Assess whether the current value

of accounts receivable is sufficient of accounts receivable is sufficient to cover the unpaid portion of a to cover the unpaid portion of a loan collateralized by accounts loan collateralized by accounts receivablereceivable


ExamineExamine• changes in provision for uncollectible changes in provision for uncollectible

accounts relative to salesaccounts relative to sales• the balance in allowance for uncollectible the balance in allowance for uncollectible

accounts relative to gross accounts receivableaccounts relative to gross accounts receivable• the amount of accounts written off as the amount of accounts written off as

uncollectible relative to gross accounts uncollectible relative to gross accounts receivablereceivable

• the number of days receivables are the number of days receivables are outstandingoutstanding

InventoriesInventories

ExamineExamine• Changes in inventory turnover rateChanges in inventory turnover rate• Cost of goods sold to sales Cost of goods sold to sales

percentagepercentage• Mix of raw materials, work in process Mix of raw materials, work in process

inventories, and finished goods inventories, and finished goods inventories to identify possible inventories to identify possible inventory obsolescence problemsinventory obsolescence problems

InventoriesInventories

LIFO inventories market value exceed LIFO inventories market value exceed the book valuethe book value

FIFO inventories will be closer to market FIFO inventories will be closer to market valuevalue

Using footnotes on the excess of market Using footnotes on the excess of market or FIFO value over LIFO cost permit the or FIFO value over LIFO cost permit the analyst to assess the adequacy of LIFO analyst to assess the adequacy of LIFO inventories to cover the unpaid balance inventories to cover the unpaid balance on a loan collateralized by inventorieson a loan collateralized by inventories

Property, Plant and Property, Plant and EquipmentEquipment

Fixed assets as collateral for long-term Fixed assets as collateral for long-term borrowingborrowing

Determining the market values of such Determining the market values of such assets is difficult using reported assets is difficult using reported financial statement information because financial statement information because the use of historical cost valuationsthe use of historical cost valuations

Market values of unique, firm-specific Market values of unique, firm-specific assets are particularly difficult to assets are particularly difficult to ascertain.ascertain.

Property, Plant and Property, Plant and EquipmentEquipment

Clues indicating market value Clues indicating market value declines include declines include • restructuring chargesrestructuring charges• asset impairment charges related to asset impairment charges related to

such assetssuch assets• recent sales at a lossrecent sales at a loss

Nonsecured lendingNonsecured lending

Study the notes to the financial Study the notes to the financial statements to ascertain how much statements to ascertain how much of the borrower’s assets are not of the borrower’s assets are not already pledged or restrictedalready pledged or restricted

The liquidation value of such The liquidation value of such assets represents the available assets represents the available resources of a firm to repay resources of a firm to repay unsecured creditorsunsecured creditors

Nonsecured lendingNonsecured lending

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

major shareholdersmajor shareholders

Capacity for DebtCapacity for Debt

A firm’s capacity to assume additional A firm’s capacity to assume additional debtdebt

A firm’s cash flows and collateral A firm’s cash flows and collateral represent the means to repay the debtrepresent the means to repay the debt

Most firms do not borrow up to the limit Most firms do not borrow up to the limit of their debt capacityof their debt capacity

Lenders want to make sure that a Lenders want to make sure that a margin of safety existsmargin of safety exists

Capacity for Debt:Capacity for Debt:Debt RatiosDebt Ratios

long-term debt ( total liabilities )long-term debt ( total liabilities )

/ total assets/ total assets long-term debt ( total liabilities ) long-term debt ( total liabilities )

/shareholders’ equity/shareholders’ equity consider off-balance sheet obligationsconsider off-balance sheet obligations

• operating lease commitmentsoperating lease commitments• underfunded pensionunderfunded pension• health care benefit obligationhealth care benefit obligation

Capacity for Debt:Capacity for Debt:Debt RatiosDebt Ratios

The higher the debt ratiosThe higher the debt ratios The higher the credit riskThe higher the credit risk The lower the unused debt The lower the unused debt

capacity of the firmcapacity of the firm

Capacity for Debt:Capacity for Debt:Interest Coverage RatioInterest Coverage Ratio

Operating income before interest Operating income before interest and taxes / interest paymentsand taxes / interest payments

A measure of margin of safety A measure of margin of safety provided by operations to service provided by operations to service debtdebt


When firms make heavy use of When firms make heavy use of operating leases for their fixed assets, operating leases for their fixed assets, the analyst might convert the operating the analyst might convert the operating leases to capital leases for the purpose leases to capital leases for the purpose of computing the interest coverage ratioof computing the interest coverage ratio

add back the lease payments to net add back the lease payments to net incomeincome

include the lease payments in the include the lease payments in the denominatordenominator


<2 high credit risk<2 high credit risk > 4 capacity to carry additional > 4 capacity to carry additional

debtdebt

ContingenciesContingencies

Is the firm a defendant in a major Is the firm a defendant in a major lawsuit involving its principal productslawsuit involving its principal products

Negative legal judgments will likely Negative legal judgments will likely have a more pronounced effect on have a more pronounced effect on smaller firmssmaller firms• less resource to defend themselvesless resource to defend themselves• less resource to sustain such lossesless resource to sustain such losses• may not carry adequate insurancemay not carry adequate insurance


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


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


Is the firm dependent on one or a Is the firm dependent on one or a few few • key employees, key employees, • contracts contracts • license agreements, orlicense agreements, or• technologies technologies

whose loss could substantially whose loss could substantially affect the viability of the business?affect the viability of the business?


Examine notes to the financial Examine notes to the financial statementsstatements

Ask questions of management, Ask questions of management, attorneys and others.attorneys and others.

Character of ManagementCharacter of Management

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


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


Does the firm have a reputation for Does the firm have a reputation for honest and fair dealings with suppliers, honest and fair dealings with suppliers, customers, bankers, and others?customers, bankers, and others?

Do managers have a substantial Do managers have a substantial portion of their personal wealth portion of their personal wealth invested in the firm’s common equityinvested in the firm’s common equity• managers have incentives to operate the managers have incentives to operate the

firm profitably and avoid defaulting on debt firm profitably and avoid defaulting on debt to increse the value of their equity holdingto increse the value of their equity holding

ConditionsConditions

Lenders often place restrictions or Lenders often place restrictions or constraints on a firm to protect their constraints on a firm to protect their interestsinterests• Minimum level of certain financial ratios Minimum level of certain financial ratios

(current ratio > 1.2))(current ratio > 1.2))• maximum level of certain financial ratios maximum level of certain financial ratios

(debt/equity ratio < 75%)(debt/equity ratio < 75%)• Restrictions on paying dividendsRestrictions on paying dividends• Limit on new financingLimit on new financing

ConditionsConditions

Debt covenants can protect the Debt covenants can protect the interest of senior, collateralized lendersinterest of senior, collateralized lenders• protection again undue deterioration in the protection again undue deterioration in the

financial condition of a firmfinancial condition of a firm They can place less senior lenders in They can place less senior lenders in

jeopardy if the firm must quickly jeopardy if the firm must quickly liquidate assets to repay debtliquidate assets to repay debt• increase the likelihood of default or increase the likelihood of default or

bankruptcy if the constraints are too tightbankruptcy if the constraints are too tight

The Bankruptcy ProcessThe Bankruptcy Process

firms may file under Chapter XI of firms may file under Chapter XI of the National Bankruptcy Codethe National Bankruptcy Code

Firms have four months to present Firms have four months to present a plan of reorganization to the a plan of reorganization to the courtcourt

After four months, creditors, After four months, creditors, employees and others can file their employees and others can file their plans of reorganizationplans of reorganization


The court decides which plan The court decides which plan provides the fairest treatment for provides the fairest treatment for all parties concernedall parties concerned

When the court determines that When the court determines that the firm has executed the plan of the firm has executed the plan of reorganization successfully and reorganization successfully and appears to be viable entity, the appears to be viable entity, the firm is released from bankruptcyfirm is released from bankruptcy


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

Models of Bankruptcy Models of Bankruptcy PredictionPrediction

Univariate Bankruptc;y Prediction Univariate Bankruptc;y Prediction Models examine the relation Models examine the relation between a particular financial between a particular financial statement ratio and bankruptcystatement ratio and bankruptcy

Univariate Bankruptcy Univariate Bankruptcy Prediction ModelsPrediction Models

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


The six ratios with the best The six ratios with the best discriminating power arediscriminating power are

(long-term solvency risk(long-term solvency risk• NI before depreciation, depletion and NI before depreciation, depletion and

amortization/ Total Liabilitiesamortization/ Total Liabilities ProfitabilityProfitability

• NI/Total AssetsNI/Total Assets


Long-term solvency riskLong-term solvency risk• Total Debt/ Total AssetsTotal Debt/ Total Assets

Short-term liquidity riskShort-term liquidity risk• Net working capital/Total AssetsNet working capital/Total Assets

Short-term liquidity riskShort-term liquidity risk• Current Assets/ Current LiabilitiesCurrent Assets/ Current Liabilities

Short-term liquidity riskShort-term liquidity risk• Cash, marketable securities, accounts Cash, marketable securities, accounts

receivable/operating expensesreceivable/operating expenses

Multivariate Bankruptcy Multivariate Bankruptcy Prediction ModelsPrediction Models

Multiple Discriminant Analysis Multiple Discriminant Analysis (MDA)(MDA)

The best-known MDA bankruptcy The best-known MDA bankruptcy prediction model is Altman’s Z-prediction model is Altman’s Z-scorescore

Altmans Bankruptcy Altmans Bankruptcy Prediction Model Prediction Model

Z = 1.2(NWC/TA)+ 1.4(RE/TA)+ Z = 1.2(NWC/TA)+ 1.4(RE/TA)+ 3.3(EBIT/TA) + .6(MV-EQ/BV-Liab)+ 3.3(EBIT/TA) + .6(MV-EQ/BV-Liab)+ 1.0(S/TA)1.0(S/TA)

MWC/TA1:(current assets - current MWC/TA1:(current assets - current liabilities)/total assetsliabilities)/total assets

measure the proportion of total assets measure the proportion of total assets representing relatively liquid net current representing relatively liquid net current assets (ST liquidity risk)assets (ST liquidity risk)

Altman’s Bankruptcy Altman’s Bankruptcy Prediction ModelPrediction Model

RE/TA: retained earnings / total RE/TA: retained earnings / total assetsassets

measures accumulated profitability measures accumulated profitability and relative age of a firmand relative age of a firm

EBIT/TA: EBIT / total assetsEBIT/TA: EBIT / total assets measures current profitabilitymeasures current profitability

Altman’s Bankruptcy Altman’s Bankruptcy Prediction Model Prediction Model

MV-EQ/BV-Liab: market value of MV-EQ/BV-Liab: market value of preferred and common equity / preferred and common equity / book value of total liabilitiesbook value of total liabilities

market’s overall assessment of the market’s overall assessment of the profitability and risk of the firmprofitability and risk of the firm

S/TA: sales / total assetsS/TA: sales / total assets measures ability of a firm to use measures ability of a firm to use

assets to generate salesassets to generate sales

Altman’s Bankruptcy Altman’s Bankruptcy Prediction ModelPrediction Model

If Z > 2.99 assign to nonbankrupt If Z > 2.99 assign to nonbankrupt group, low probability of group, low probability of bankruptcybankruptcy

If Z < 1.81 assign to bankrupt If Z < 1.81 assign to bankrupt group, higher probability of group, higher probability of bankruptcybankruptcy

1.81 < Z < 2.99 gray area1.81 < Z < 2.99 gray area

Multivariate Bankruptcy Multivariate Bankruptcy Prediction ModelsPrediction Models

James Ohlson used Logit Analysis James Ohlson used Logit Analysis to discriminate bankrupt from non-to discriminate bankrupt from non-bankrupt firmsbankrupt firms

y=-1.32 - 0.407(SIZE) + y=-1.32 - 0.407(SIZE) + 6.03(TLTA) - 1.43(WCTA) + 6.03(TLTA) - 1.43(WCTA) + 0.0757(CLCA) - 2.37)NITA) - 0.0757(CLCA) - 2.37)NITA) -

1.83 (FUTL) + 0.285 (INTWO) - 1.83 (FUTL) + 0.285 (INTWO) - 1.72 (OENEG) - 0.521 (CHIN)1.72 (OENEG) - 0.521 (CHIN)

Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis

Size: larger firms have greater Size: larger firms have greater flexibility to curtail capacity, sell flexibility to curtail capacity, sell assets, and attract debt or equity assets, and attract debt or equity capital than smaller firmscapital than smaller firms

TLTA (Total Liabilities/ Total Assets) :TLTA (Total Liabilities/ Total Assets) :• Long-term solvency riskLong-term solvency risk• Higher debt ratios increase the Higher debt ratios increase the

probability of bankruptcyprobability of bankruptcy


WCTA (Working capital/Total WCTA (Working capital/Total Assets:Assets:• the higher the proportion of net the higher the proportion of net

working capital to total assets, working capital to total assets, • the more liquid are the assetsthe more liquid are the assets• the lower the probability of the lower the probability of

bankruptcybankruptcy


CLCA (Current Liabilities/Current CLCA (Current Liabilities/Current Assets):Assets):• An excess of current liabilities over An excess of current liabilities over

current assets is also an indicator of current assets is also an indicator of short-term liquidity riskshort-term liquidity risk


NITA (Net Income/Total Assets):NITA (Net Income/Total Assets):• the higher the rate of profitability,the higher the rate of profitability,• the less likely a firm will experience the less likely a firm will experience

difficulty servicing debtdifficulty servicing debt• the lower the probability of bankruptythe lower the probability of bankrupty


FUTL (Funds (Working capital) from FUTL (Funds (Working capital) from operations/ Total Liabilities):operations/ Total Liabilities):• the greater the ability of working the greater the ability of working

capital from operations to cover total capital from operations to cover total liabilitiesliabilities

• the lower the probability of the lower the probability of bankruptcybankruptcy


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

increases the probability of increases the probability of bankruptcybankruptcy


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

negativenegative


CHIN (Net incomeCHIN (Net income (t) - Net Income (t-(t) - Net Income (t-1))/(INet Income (t)I + Inet Income (t-1))/(INet Income (t)I + Inet Income (t-1)I1)I

The change in net income indicates The change in net income indicates the direction and magnitude of the direction and magnitude of earnings growth or decline.earnings growth or decline.• Increasing (decreasing) earnings coupled Increasing (decreasing) earnings coupled

with the negative coefficient suggest a with the negative coefficient suggest a lower (higher) probability of bankruptylower (higher) probability of bankrupty

Synthesis of Bankruptcy Synthesis of Bankruptcy Prediction ResearchPrediction Research

Investment FactorsInvestment Factors Relative Liquidity of a Firm’s Relative Liquidity of a Firm’s

AssetsAssets Rate of Asset TurnoverRate of Asset Turnover

Relative Liquidity of a Relative Liquidity of a Firm’s AssetsFirm’s Assets

Firm’s with relatively large proportions Firm’s with relatively large proportions of current assets tend to experience of current assets tend to experience less financial distress than firms whose less financial distress than firms whose dominant assets are fixed assets or dominant assets are fixed assets or intangible assetsintangible assets

Expected return on the more liquid Expected return on the more liquid assets is usually less than the expected assets is usually less than the expected return from fixed and intangible assets return from fixed and intangible assets reflecting its lower riskreflecting its lower risk

Relative Liquidity of a Relative Liquidity of a Firm’s AssetsFirm’s Assets

Firms must balance their mix of Firms must balance their mix of assets to obtain the desired assets to obtain the desired return/risk profilereturn/risk profile

Ratios includeRatios include• Cash/Total assetsCash/Total assets• Current assets/total assetsCurrent assets/total assets• net working capital/total assetsnet working capital/total assets

Rate of Asset TurnoverRate of Asset Turnover

The more quickly assets turn over, The more quickly assets turn over, the more quickly funds work their the more quickly funds work their way toward cash on the balance way toward cash on the balance sheetsheet• Retailer has same fixed assets to total Retailer has same fixed assets to total

assets as a manufacturing firm, but assets as a manufacturing firm, but higher turnover ratios thus more higher turnover ratios thus more liquid.liquid.

Rate of Asset TurnoverRate of Asset Turnover

Ratios includeRatios include• total assets turnovertotal assets turnover• accounts receivable turnoveraccounts receivable turnover• inventory turnoverinventory turnover• the working capital turnoverthe working capital turnover• fixed asset turnoverfixed asset turnover

Financing FactorsFinancing Factors

Relative Proportion of Debt in the Relative Proportion of Debt in the Capital StructureCapital Structure• the higher the proportion of liabilities in the higher the proportion of liabilities in

the capital structurethe capital structure• the higher the probability that firms will the higher the probability that firms will

experience bankruptcyexperience bankruptcy• Firms with lower levels of debt tend to Firms with lower levels of debt tend to

have unused borrowing capacity that have unused borrowing capacity that they can depend on in times of difficultythey can depend on in times of difficulty

Financing FactorsFinancing Factors

Relative Proportion of Short-Term Relative Proportion of Short-Term Debt in the Capital StructureDebt in the Capital Structure• The more imminent due dates of debt The more imminent due dates of debt

exacerbate the risk of bankruptcyexacerbate the risk of bankruptcy Ratio includeRatio include

• Current liabilities/total assetsCurrent liabilities/total assets

Operating FactorsOperating Factors

Relative Level of ProfitabilityRelative Level of Profitability• Profitable firms ultimately turn their Profitable firms ultimately turn their

earnings into cashearnings into cash• Firms with low or negative profitability Firms with low or negative profitability

must often rely on available cash or must often rely on available cash or additional borrowing to meet financial additional borrowing to meet financial commitments as they come duecommitments as they come due

• Weak profitability and high debt ratios Weak profitability and high debt ratios usually spells financial distressusually spells financial distress


Profitability ratios:Profitability ratios:• net income/assetsnet income/assets• income before interest and income before interest and

taxes/assetstaxes/assets• net income/salesnet income/sales• cash flow from operations/assetscash flow from operations/assets


Variability of OperationsVariability of Operations Firms that experience variability in their Firms that experience variability in their

operations (cyclical sales patterns) are operations (cyclical sales patterns) are more in danger of bankruptcy than firms more in danger of bankruptcy than firms with less variabilitywith less variability

measure:measure:• change in saleschange in sales• change in net income from the previous yearchange in net income from the previous year

Other Possible Explanatory Other Possible Explanatory VariablesVariables

SizeSize• Larger firms generally have access to Larger firms generally have access to

a wider range of financing sources as a wider range of financing sources as well as more flexibility to redeploy well as more flexibility to redeploy assets than smaller firmsassets than smaller firms

• Larger firms are less subject to Larger firms are less subject to bankruptcy than smaller firmsbankruptcy than smaller firms


GrowthGrowth• Rapidly growing firms often need Rapidly growing firms often need

external financing to cover cash external financing to cover cash shortfalls from operations and permit shortfalls from operations and permit acquisitions of fixed assetsacquisitions of fixed assets

• they display high debt ratios and weak they display high debt ratios and weak profitabilityprofitability

• But their growth potential provides But their growth potential provides access to capital that permits to surviveaccess to capital that permits to survive


Qualified Audit OpinionQualified Audit Opinion• has much the same predictive has much the same predictive

accuracy as the models based on accuracy as the models based on financial ratiosfinancial ratios

Market RiskMarket Risk

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

Market Rate of ReturnMarket Rate of Return

Return on common stock = Return on common stock =

Risk Free interest rate + Market Risk Free interest rate + Market beta ( market return - risk free beta ( market return - risk free interest rate)interest rate)

The beta coefficient measures the The beta coefficient measures the covariability of a firm’s returns covariability of a firm’s returns with those of all shares traded on with those of all shares traded on the marketthe market

Market RiskMarket Risk

Beta captures the systematic riskBeta captures the systematic risk The pricing of common stock The pricing of common stock

rewards shareholders they assumerewards shareholders they assume An investor can eliminate An investor can eliminate

nonsystematic risk by a diversified nonsystematic risk by a diversified portfolioportfolio

Market Beta Market Beta

Three principal explanatory Three principal explanatory variablesvariables• Degree of operating leverageDegree of operating leverage• Degree of financial leverageDegree of financial leverage• Variability of salesVariability of sales

Market BetaMarket Beta

Firms with a market beta of 1 experience Firms with a market beta of 1 experience variability equal to the averagevariability equal to the average

Firms with a market beta of more than Firms with a market beta of more than 1experience greater variability than the 1experience greater variability than the averageaverage

Firms with a beta of less than 1 Firms with a beta of less than 1 experience less variability than the experience less variability than the average firmaverage firm

Exhibit 9.6 Exhibit 9.6

UtilitiesUtilities

Have capital-intensive facilities and Have capital-intensive facilities and use extensive borrowing to finance use extensive borrowing to finance their acquisitiontheir acquisition

lowest assets turnover ratioslowest assets turnover ratios highest capital structure leverage highest capital structure leverage

ratiosratios ROCE is smallest of all the industriesROCE is smallest of all the industries Their market beta is the smallestTheir market beta is the smallest

Metals and Metal ProductsMetals and Metal Products

The metals industry takes iron ore The metals industry takes iron ore and other minerals and processes and other minerals and processes them into steel and other them into steel and other intermediate productsintermediate products

Capital intensiveCapital intensive Products tend to portray Products tend to portray

commodity characteristicscommodity characteristics


The metal products industry takes The metal products industry takes steel and other intermediate steel and other intermediate products and processes them into products and processes them into final products that have an final products that have an element of differentiationelement of differentiation

less capital intensiveless capital intensive faster asset turnover than the faster asset turnover than the

metals industrymetals industry


Similar capital structure leverage Similar capital structure leverage ratiosratios

ROCE is higher for the metal ROCE is higher for the metal products segment - differentiated products segment - differentiated productproduct

Market beta of metal products is Market beta of metal products is less than that for metalsless than that for metals

Grocery Stores, Food Grocery Stores, Food Processors and Processors and RestaurantsRestaurants

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

Amusements and hotelsAmusements and hotels

Heavy investments in fixed assets and debtHeavy investments in fixed assets and debt Economic conditions affect the demand for Economic conditions affect the demand for

their productstheir products Amusement industry experienced much less Amusement industry experienced much less

variability in its ROCE than hotelsvariability in its ROCE than hotels The amusements industry is also less capital The amusements industry is also less capital

intensive and debt intensive than hotelsintensive and debt intensive than hotels Amusement (.74) smaller beta than Hotel Amusement (.74) smaller beta than Hotel

(.95)(.95)

Printing and Publishing, Printing and Publishing, Lumber, and PaperLumber, and Paper

Paper industry is more capital-intensive Paper industry is more capital-intensive and debt-intensive than the printing and debt-intensive than the printing and publishing industry and the lumber and publishing industry and the lumber industryindustry

Expect market beta for printing lower Expect market beta for printing lower than lumber lower than paper industrythan lumber lower than paper industry

But 3 market betas are similar (.88, .89, But 3 market betas are similar (.88, .89, .89).89)

PetroleumPetroleum

Capital and debt intensiveCapital and debt intensive Std deviation of ROCE relatively Std deviation of ROCE relatively

highhigh Market beta the smallest of 22 Market beta the smallest of 22

industriesindustries

Bankruptcy risk and Bankruptcy risk and Market Beta RiskMarket Beta Risk

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


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


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


Bankruptcy risk relates primarily to Bankruptcy risk relates primarily to an illiquidity probleman illiquidity problem

Market beta risk relates more to an Market beta risk relates more to an earnings problemearnings problem

Bankruptcy risk when it becomes Bankruptcy risk when it becomes important for a particular firm important for a particular firm intensifies the underlying market intensifies the underlying market beta riskbeta risk

Risk Analysis: An Extended Look Dr. Nancy Mangold California State University, East Bay.

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Transcript of Risk Analysis: An Extended Look Dr. Nancy Mangold California State University, East Bay.