Chapter 5

Risk Analysis
 Sources of Risk
• Firm-Specific
• Industry
• Domestic
• International

Chapter: 05 2
 Disclosures Regarding Risk
and Risk Management

In paragraph 229.503(c) of Regulation S-K, the SEC states the

following:
• Where appropriate, provide under the caption ‘‘Risk Factors’’
a discussion of the most significant factors that make the
offering speculative or risky. This discussion must be concise
and organized logically. Do not present risks that could apply
to any issuer or any offering. Explain how the risk affects the
issuer or the securities being offered (usually Item 1A in 10-K).

Chapter: 05 3
 Financial Statement Analysis of Risk
Types of Risk:
 Financial flexibility
 Short-term liquidity risk
 Long-term solvency risk
 Credit risk
 Bankruptcy risk
 Systematic risk

Chapter: 05 4
 Analyzing Financial Flexibility
(Screen 1 of 2)
• Financial leverage can enhance the return to
common shareholders.
• Disaggregation of ROCE provides insight about
the degree of benefit derived from using
leverage.
• Higher leverage generally suggests greater
financial risk.

Chapter: 05 5
 Analyzing Financial Flexibility
(Screen 2 of 2)
An alternative disaggregation of ROCE from
the one discussed in the previous chapter is:
ROCE = Operating ROA + (Leverage x Spread)

Where :
NOPAT
Operating ROA =
Average Net Operating Assets
Financing Obligations
Leverage =
Common Equity
Spread = OperatingROA − NetBorrowingRate

Chapter: 05 6
 Analyzing Short-Term Liquidity Risk
• Measures a firm’s ability to generate
sufficient cash to supply operating working
capital needs and to service debts.
• Short-term liquidity problems can arise from
the following:
– Untimed cash inflows and outflows.
– High Degree of long-term leverage.

Chapter: 05 7
 Short-Term Liquidity Risk
(Screen 1 of 2)
Financial statement ratios:
• Current ratio: It indicates the amount of cash
available and other current assets of the firm,
relative to obligations coming due.
• Quick ratio:
– Also called as Acid Test Ratio.
– Includes only those current assets the firm could convert
quickly into the cash (e.g., Cash, Marketable securities and
Receivables).

Chapter: 05 8
 Short-Term Liquidity Risk
(Screen 2 of 2)
• Operating cash flow to current liabilities.
• Working capital activity ratios: Rate of activity
measures used to study cash-generating ability of
operations and short-term liquidity risk of a firm are:
– Accounts Receivable Turnover
– Inventory Turnover
– Accounts Payable Turnover

Chapter: 05 9
Analyzing Long-Term Solvency Risk
 Examines a firm’s ability to make interest and
principal payments on long-term debt and
similar obligations.
 Three measures used to examine long-term
solvency risk are:
 Debt ratios
 Interest coverage ratio
 Operating cash flow to total liabilities ratio
Chapter: 05 10
 Long-Term Solvency Risk
(Screen 1 of 2)
 Debt Ratios:
 It is used to measure the amount of liabilities,
particularly long-term debt in a firm’s capital
structure.
 The higher this proportion, the greater the long-
term solvency risk.
 It is the alternative computation of leveraged
used in the ROCE, in previous chapter.

Chapter: 05 11
 Long-Term Solvency Risk
(Screen 2 of 2)
 Commonly used measures of Debt Ratios:

Chapter: 05 12
 Long-Term Liquidity Risk
• Interest coverage ratio:
– It indicates the number of times a firm’s income or
cash flows could cover interest charges.

Chapter: 05 13
 Long-Term Liquidity Risk

 Operating cash flow to total liabilities ratio:

 Considers the firm’s ability to generate cash flow
from operations to service debt.

Chapter: 05 14
 Analyzing Credit Risk (Screen 1 of 2)
• Potential lenders to a firm assess the
likelihood that the firm will pay periodic
interest and repay the principal amount.
• Lenders may use following checklist as
factors.
– Circumstances leading to need for loan.
– Credit History
• Has a firm borrowed in past and successfully repaid it?
• Poor credit history can doom a firm to failure.
Chapter: 05 15
Analyzing Credit Risk (Screen 2 of 2)
– Cash flows
• Lenders prefer that the firm generates sufficient cash
flows to pay interest and repay principal on a loan
rather than selling the collateral.
– Collateral
– Capacity for debt
Contingencies
Character of Management
Communication
Conditions or covenants
Chapter: 05 16
 Analyzing Bankruptcy Risk
(Screen 1 of 2)
• Models for bankruptcy prediction
– Univariate bankruptcy prediction models: Error
types
• Examines the relation between a particular financial
statement ratio and bankruptcy.

Chapter: 05 17
 Analyzing Bankruptcy Risk
(Screen 2 of 2)
– Bankruptcy prediction models using multiple
discriminant analysis (MDA):
• Altman’s Z-score

– Z less than 1.81 indicates high probability of bankruptcy.

– Z greater than 3.00 indicates low probability of bankruptcy.
– Scores between 1.81 and 3.00 are in the gray area.
Chapter: 05 18
 Bankruptcy Prediction Research
(Screen 1 of 2)

• It summarizes the factors for bankruptcy most

consistently across various studies.
– Investment Factors:
• Relative Liquidity of a firm’s Assets
• Rate of Asset Turnover

Chapter: 05 19
 Bankruptcy Prediction Research
(Screen 2 of 2)
– Financing Factors:
• Relative Proportion of Debt
• Relative Proportion of Short-term Debt
– Operating Factors:
• Relative level of profitability
• Variability of operations
– Other possible explanatory variables:
• Size
• Growth
• Qualified Audit Opinion
Chapter: 05 20
 Systematic Risk
 Beta coefficient measures the covariability of
a firm’s return with the returns of a
diversified portfolio of all shares traded on
the market.
 Beta is a measure of the Systematic risk of
the firm.

Chapter: 05 21