Risk Analysis: An Extended Look
Dr. Nancy Mangold
California State University, East Bay
Credit Risk
 A firm’s ability to make interest and
principal payments on borrowings
Bankruptcy Risk
 The likelihood that a firm will file for
bankruptcy and perhaps subsequently
liquidate
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
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 firm’s
position on this financial distress
continuum.
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
Risk measure :
Market equity beta
 Market equity beta used as the measure of
risk
 Market equity beta measures the
covariability of a firm’s returns with the
returns of all securities in the market
Sources of Debt Financing:
Commercial 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
Sources of Debt Financing:
Commercial 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
Sources of Debt Financing:
Other 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
Sources of Debt Financing:
Commercial 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
Sources of Debt Financing:
Commercial 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
Sources of Debt Financing:
Unsecured 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
Sources of Debt Financing:
Unsecured Debt Market
 In Bankruptcy
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•
•
•
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
Sources of Debt Financing:
Suppliers
 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
Credit Risk Analysis
 Circumstances leading to need for the loan
 Cash Flows
 Collateral
 Capacity for Debt
 Contingencies
 Character of Management
 Conditions
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
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
W.T. Grant Company
 Lending to satisfy cash flow needs related
to an unsolved problem or difficulty can be
highly risky
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 doesn’t collect
cash from customers until December,
January or later
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
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 20to 25-year loans
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-Mart’s operating success in the past
• the land and buildings that serve as collateral
for the loans
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 .
Data General Corporation
 Wanted to develop new technologies for
internet products
 Needed to borrow funds to finance its
research and development effort
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
• R&D expenditures may not result in assets that
can be serve as collateral for the loan
Lower credit risk
 Lending to established firms for ongoing
operating needs
Higher credit risks
 Lending to firms experiencing operating
problems
 Lending to emerging businesses
 Lending to support investments in
intangible assets typically carry higher
risks
Cash Flows
 Lenders want firms to generate sufficient
cash flow to pay interest and repay
principal on a loan so they don’t have to
rely on selling the collateral
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
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
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
Indicators of potential cash flow
problems
 Capital expenditures that substantially
exceed cash flow from operations
• indicates a firm’s continuing need for external
financing to sustain growth
 Reductions in capital expenditures over
time
• signal declines in future sales, earnings, and
operating cash flows
Indicators of potential cash flow
problems
 Sales of marketable securities in excess of
purchases of marketable securities
• signal the inability of a firm’s operations to
provide adequate cash flow to finance working
capital and long-term investments
Indicators of potential cash flow
problems
 A substantial shift from long-term
borrowing to short-term borrowing
• signal a firm’s inability to obtain long-term
loans because lenders are uncertain about a
firm’s future
 A reduction or elimination of dividend
payments
• a negative signal about a firm’s future
prospects
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
Cash Flow Financial Ratios
 Cash flow from operations
Average Total Liabilities
 Indicates a firm’s ability to generate
sufficient cash flow to repay all liabilities
Cash Flow Financial Ratios
 Cash flow from operations
Capital Expenditures
 Indicates the ability of a firm to finance
capital expenditures with operating cash
flows
 <1 indicates a will need to continue to find
various sources of capital to finance
capital expenditures to continue its growth
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 borrower’s ability to repay the loan with
interest as it comes due
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
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
Collateral
 Marketable Securities reported at at
market value on balance sheet (< 20%
ownership)
 Assess whether the market value of
securities pledged as collateral exceeds
the unpaid balance of a loan
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
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
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
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
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.
Property, Plant and Equipment
 Clues indicating market value declines
include
• restructuring charges
• asset impairment charges related to such
assets
• recent sales at a loss
Nonsecured lending
 Study the notes to the financial statements
to ascertain how much of the borrower’s
assets are not already pledged or
restricted
 The liquidation value of such assets
represents the available resources of a
firm to repay unsecured creditors
Nonsecured lending
 For small business, additional source of
collateral may be
• personal assets of management or major
shareholders
Capacity for Debt
 A firm’s capacity to assume additional debt
 A firm’s 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
Capacity for Debt:
Debt 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
Capacity for Debt:
Debt Ratios
 The higher the debt ratios
 The higher the credit risk
 The lower the unused debt capacity of the
firm
Capacity for Debt:
Interest Coverage Ratio
 Operating income before interest and taxes
/ interest payments
 A measure of margin of safety provided by
operations to service debt
Capacity for Debt:
Interest 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
Capacity for Debt:
Interest Coverage Ratio
 <2
high credit risk
 > 4 capacity to carry additional debt
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
Contingencies
 Has the firm served as guarantor on a loan
by a subsidiary, joint venture, or corporate
officer
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?
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?
Contingencies
 Examine notes to the financial statements
 Ask questions of management, attorneys
and others.
Character of Management
 Has the management team successfully
weathered previous operating problems
and challenges that could have bankrupted
most firms?
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
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 firm’s
common equity
• managers have incentives to operate the firm
profitably and avoid defaulting on debt to
increse the value of their equity holding
Conditions
 Lenders often place restrictions or
constraints on a firm to protect their
interests
• Minimum level of certain financial ratios
(current ratio > 1.2))
• maximum level of certain financial ratios
(debt/equity ratio < 75%)
• Restrictions on paying dividends
• Limit on new financing
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
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
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
The Bankruptcy Process
 A Chapter XII filing for bankruptcy entails
an immediate sale or liquidation of the
firm’s assets and a distribution of the
proceeds to the various claimants in the
order of their priority.
Models of Bankruptcy Prediction
 Univariate Bankruptc;y Prediction Models
examine the relation between a particular
financial statement ratio and bankruptcy
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
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
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
Multivariate Bankruptcy
Prediction Models
 Multiple Discriminant Analysis (MDA)
 The best-known MDA bankruptcy prediction
model is Altman’s Z-score
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)

Altman’s 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
Altman’s Bankruptcy Prediction
Model
 MV-EQ/BV-Liab: market value of preferred
and common equity / book value of total
liabilities
 market’s 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
Altman’s Bankruptcy Prediction
Model
 If Z > 2.99
assign to nonbankrupt group, low
probability of bankruptcy
 If Z < 1.81 assign to bankrupt group, higher
probability of bankruptcy
 1.81 < Z < 2.99 gray area
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)
Multivariate Bankruptcy Model:
Logit 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
Multivariate Bankruptcy Model:
Logit 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
Multivariate Bankruptcy Model:
Logit Analysis
 CLCA (Current Liabilities/Current Assets):
• An excess of current liabilities over current
assets is also an indicator of short-term
liquidity risk
Multivariate Bankruptcy Model:
Logit 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
Multivariate Bankruptcy Model:
Logit 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
Multivariate Bankruptcy Model:
Logit 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
Multivariate Bankruptcy Model:
Logit Analysis
 OENEG (One if total liabilities exceed total
assets and zero otherwise):
• appears redundant with TLTA
• coefficient should be positive but is negative
Multivariate Bankruptcy Model:
Logit 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
Synthesis of Bankruptcy
Prediction Research
 Investment Factors
 Relative Liquidity of a Firm’s Assets
 Rate of Asset Turnover
Relative Liquidity of a Firm’s
Assets
 Firm’s 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
Relative Liquidity of a Firm’s
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
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.
Rate of Asset Turnover
 Ratios include
•
•
•
•
•
total assets turnover
accounts receivable turnover
inventory turnover
the working capital turnover
fixed asset turnover
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
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
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
Operating Factors
 Profitability ratios:
•
•
•
•
net income/assets
income before interest and taxes/assets
net income/sales
cash flow from operations/assets
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
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
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
Other Possible Explanatory
Variables
 Qualified Audit Opinion
• has much the same predictive accuracy as the
models based on financial ratios
Market Risk
 Economic theory teaches that differences
in expected rates of return for different
investment alternatives should relate to
differences in risk
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 firm’s returns with those
of all shares traded on the market
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
Market Beta
 Three principal explanatory variables
• Degree of operating leverage
• Degree of financial leverage
• Variability of sales
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
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
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
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
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
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
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
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)
Petroleum
 Capital
and debt intensive
 Std deviation of ROCE relatively high
 Market beta the smallest of 22 industries
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).
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)
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)
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