Professional Documents
Culture Documents
Alexandru Cebotari
Sources and Types of Risks
Source Type or Nature
International Exchange Rate Changes
Host Government Regulations
Political Unrest
Expropriation of Assets
Domestic Recession
Inflation or Deflation
Interest Rate Changes
Demographic Changes
Political Changes
Industry Technology
Competition
Availability of Raw Materials and Labor
Unionization
Firm-Specific Management Competence
Strategic Direction
Lawsuits
• A firm should continually monitor each of these and other
type of risks
• A loan officers task is to understand how a firm monitors its
risks
• Analysis of the financial consequences of these elements of
risk using financial statements is an important tool
• Various financial reporting standards require firms to discuss
in notes to financial statements how important elements of risk
affect a particular firm and the actions it takes to manage its
risks
• In addition to using information about risk disclosed in the
notes to financial statements, loan officers typically assess the
dimensions of risk using ratios of various items in the financial
statements
Profitability, Growth, Risk
Investment and
Operating Asset Financing Dividend
Decisions Management Decisions Decisions
Decisions
Profitability of
Working Capital Short-Term Liquidity
Operations Goods and
Requirements Risk
Services Sold
Sales of Existing
Plant Capacity
Investing Plant Assets or
Requirements
Investments
Long-Term Solvency
Risk
Borrowing Debt Service
Financing
Capacity Requirements
Analysis of Short-Term Liquidity Risk
• The analysis of short-term liquidity risk requires an understanding of
the operating cycle of a firm!
• Current Ratio: mainly used to give an idea about the company’s
ability to pay back its short-term liabilities and a sense of the
efficiency of the firm’s operating cycle and its ability to turn its
products into cash (ratio ≥ 1.0 preferred)
• Quick Ratio: known as acid test, measures the firm’s ability to pay off
its short-term debt from current liquid assets; draws a more realistic
picture (trend towards 0.5)
• Operating Cash Flow Ratio: using cash flow as opposed to
accounting items provides a better indication of liquidity (40%ntypical
of a healthy firm)
A measure of short-term
liquidity. Indicates the
Current Ratio Current Assets / Current liabilities ability of entity to meet its
short-term debts from its
current assets
Measures percentage of
assets provided by
Debt ratio Total Liabilities / Total assets
creditors and extent of
using gearing
Measures percentage of
assets provided by
Capitalization ratio Total assets / Total shareholders’ equity
shareholders and the
extent of using gearing
The debt-to-capital ratio gives
users an idea of a
company's financial
Total Debt/(Total Shareholders’ Equity + structure, or how it is
Debt to Capital Ratio
Total Debt) financing its operations,
along with some insight
• Met Working Capital/Total Assets: the proportion of total assets comprising relatively liquid
net current assets (current assets minus current liabilities). It is a measure of short-term
liquidity risk.
• Market Value of Equity/Book Value of Liabilities: this is a form of debt/equity ratio, but it
incorporates the market’s assessment of the value of the firm’s shareholders’ equity. This
ratio measures long-term solvency risk and the market’s overall assessment of the
profitability and risk of the firm.
• Sales/Total Assets: this ratio is similar to the total assets turnover ratio and indicates the
ability of a firm to use assets to generate sales.
In applying this model, Altman found that Z-scores of less than 1.81 indicated a high
probability of bankruptcy, while Z-scores higher than 3.00 indicates a low probability of
bankruptcy. Scores between 1.81 and 3.00 were in the gray area.
Logit Analysis
Probability of Bankruptcy of a Firm:
1
p
1 ey
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,
SIZE = ln (Total Assets/GNP Deflator)
TLTA = Total Liabilities/Total Assets
WCTA = (CA-CL)/Total Assets
CLCA = Current Liabilities/Current Assets
NITA = Net Income/Total Assets
FUTL = Funds (Working Capital) from Operations/Total Liabilities
INTWO = one if Net Income (NI) was negative in the last two years and zero otherwise
OENEG = one if owners’ equity is negative and zero otherwise
CHIN = [NI (this year) – NI (last year)]/[| NI (this year)| + |NI (last year)|]
Earnings Manipulation
• How much risk economic and strategic factors pose for the
operations of a firm, its profitability and long-term solvency ?
We use the Rate of Return on Assets (ROA) to answer this
question.
Sales
Asset Turnover
Average Total Assets
Average Median ROA, Profit Margin for ROA, and Assets
Turnover for 23 industries for 1990 to 2004
Economic Factors Affecting the Profit
Margin/Assets Turnover Mix
Profit
A High Monopoly Margin
for ROA
Pure Assets
C Low
Competition Turnover
Profitability Ratios