RIsk Managcmcnt

ConcepLs and AppllcaLlon

lnsLlLuLe of 8uslness ManagemenL
May 2011
2
Cred|t k|sk Ana|ys|s Iramework
ManagemenL CuallLy Covernance
ua||tat|ve uant|tat|ve L|nk ast w|th present
rea||t|es
L|nk M|t|gat|on w|th k|sk
PlsLorlcal Analysls ro[ecL lorward MonlLor laclllLles SLrucLure laclllLles
8us|ness k|sk
WlndusLry
Wvalue urlvers
WCroup SLrucLure
WSusLalnable
Lendlng
I|nanc|a| k|sk
WLlnk no wlLh
buslness rlsk
WCash flow
llquldlLy
WCaplLal sLrucLure
gearlng
8uslness
ro[ecLlons
llnanclal
lorecasLs
roLecLlon
conLrols
rlorlLy of clalms
SecurlLy
CondlLlon
precedenLs
CovenanLs
8lsk 1rlggers
perat|ng
Cyc|e
Cash flow
sufflclenL for all
flnanclal
obllgaLlons?
roduct
pportun|t|es
CpLlmal 8lsk/8eward
Lconomlc 8evenue
rlzahmed llnanclal 8lsk ManagemenL
perat|ng and I|nanc|a| Leverage
We wlll revlew
W 1he dlfference beLween 8uslness 8lsk and llnanclal 8lsk
W CperaLlng Leverage versus llnanclal Leverage
W 8uslness rlsk ls Lhe uncerLalnLy of buslness resulLs arlslng
from
varlaLlons ln demand sales
uncerLalnLy abouL prlces and cosLs
uncerLalnLy ln process and producLlon
uncerLalnLy arlslng from lndusLry condlLlons
uncerLalnLy arlslng from compeLlLlon
uncerLalnLy arlslng from macro economlc / pollLlcal envlronmenL
4 rlzahmed llnanclal 8lsk ManagemenL
WhaL ls 8uslness 8lsk?
perat|ng and I|nanc|a| Leverage
rlzahmed llnanclal 8lsk ManagemenL
W CperaLlng Leverage ls Lhe degree of flxed cosLs relaLlve Lo Lhe varlable
cosLs ln Lhe company's operaLlons lL reflecLs Lhe exLenL Lo whlch flxed
cosLs are uLlllzed ln Lhe buslness
W uegree of operaLlng leverage may be deflned as Lhe percenLage change ln
operaLlng lncome L8l1 LhaL occurs as a resulL of a percenLage change ln
sales
W lL ls compuLed as follows
W uCL sales varlable cosLs / sales varlable cosLs flxed cosLs
W Cr uCL change ln L8l1/ change ln sales
8us|ness r|sk and operat|ng |everage
rlzahmed llnanclal 8lsk ManagemenL
W A hlgh operaLlng leverage allows companles Lo lncrease Lhelr proflLablllLy
by a hlgher proporLlon for every lncrease ln sales
W 8uL a hlgh operaLlng leverage resulLs ln hlgher buslness rlsk as a decllne ln
revenue also resulL ln a large decllne ln proflLs
8us|ness r|sk and operat|ng |everage
rlzahmed llnanclal 8lsk ManagemenL
W CperaLlng Leverage Lxample
8us|ness r|sk and operat|ng |everage
I|rm A Down 8ase Up
-o of unlLs manufacLured 200 400 20
rlce per unlL 20 20 20
vC per unlL 2 2 2
llxed CosL 1000 1000 1000
1oLal revenue 4000 8000 10400 S0 30
varlable cosL 400 800 1040
1oLal cosL 1400 1800 2040
L8l1 200 200 80 S8 3S
uegree of operaLlng leverage 14 12 11
8 rlzahmed llnanclal 8lsk ManagemenL
W CperaLlng Leverage Lxample
8us|ness r|sk and operat|ng |everage
I|rm 8 Down 8ase Up
-o of unlLs manufacLured 400
rlce per unlL 20
vC per unlL 2
llxed CosL 000
1oLal revenue 8000
varlable cosL 800
1oLal cosL 800
L8l1 4200
uegree of operaLlng leverage 12
rlzahmed llnanclal 8lsk ManagemenL
W CperaLlng Leverage Lxample
8us|ness r|sk and operat|ng |everage
I|rm 8 Down 8ase Up
-o of unlLs manufacLured
200 400 20
rlce per unlL
20 20 20
vC per unlL
2 2 2
llxed CosL
000 000 000
1oLal revenue
4000 8000 10400
S0 30
varlable cosL
400 800 1040
1oLal cosL
400 800 4040
L8l1
00 4200 0
86 S1
uegree of operaLlng leverage
0 1 1
W llnanclal leverage ls Lhe use of debL ln proposlLlon Lo equlLy
W lL ls Lhe use of debL wlLh Lhe lnLenL Lo earn a greaLer reLurn on equlLy Lhan
Lhe cosL of lnLeresL
W 1ax savlngs arlslng from lnLeresL expense as Lax deducLlble lLem reduces
cosL of borrowlng
W llnanclal leverage glves rlses Lo flnanclal rlsk because lnLeresL cosLs ls
flxed" le lL needs Lo be pald regardless of revenue level
10 rlzahmed llnanclal 8lsk ManagemenL
I|nanc|a| k|sk and I|nanc|a| |everage
uegree of flnanclal leverage ulL ls compuLed as follows
uegree of flnanclal leverage L8l1 / (L8l1 lnLeresL)
Cr
uegree of flnanclal leverage change ln LS / change ln L8l1
uegree of flnanclal leverage ls also called as 'lnLeresL coverage raLlo'
11 rlzahmed llnanclal 8lsk ManagemenL
I|nanc|a| k|sk and I|nanc|a| |everage
W 8uslness rlsk depends on mulLlple facLors LhaL affecL Lhe buslness
operaLlons of a company lncludlng uncerLalnLy lnherenL ln company's cosL
sLrucLure producLlon demand lndusLry economlc and pollLlcal condlLlons
W llnanclal rlsk depends on Lhe mlx of debL and equlLy lL ls affecLed by
roporLlon of debL Lo equlLy Lhe hlgher Lhe debL Lhe hlgher Lhe
flnanclal rlsk
1ype of lnsLrumenL used
12 rlzahmed llnanclal 8lsk ManagemenL
8us|ness k|sk Vs I|nanc|a| k|sk
W CperaLlng leverage refers Lo Lhe proporLlon of flxed cosLs ln Lhe company's
operaLlons lL focuses on buslness rlsk
W llnanclal leverage refers Lo Lhe use of debL ln proporLlon Lo equlLy lL
focuses on flnanclal rlsk
W Comblned leverage refers Lo Lhe lmpacL of boLh operaLlng and flnanclal
leverage on proflLablllLy of a company
W 1he lower Lhe operaLlng leverage of a company Lhe more flexlblllLy lL has Lo lncrease lLs
flnanclal leverage
W Low operaLlng leverage can susLaln hlgher flnanclal leverage
1 rlzahmed llnanclal 8lsk ManagemenL
perat|ng Leverage Vs I|nanc|a| Leverage
W Leverage raLlos may be used as predlcLlve Lools
W Companles LhaL operaLe aL break even and hlgh operaLlng and flnanclal
leverage
More vulnerable Lo decrease ln sales
W Companles wlLh low operaLlng and flnanclal leverage
More flexlble Lo respond Lo unexpecLed down Lurns
W Leverage sLrucLures helps us Lo undersLand managemenL capablllLy and
sLraLegy
14 rlzahmed llnanclal 8lsk ManagemenL
ummary
1 rlzahmed llnanclal 8lsk ManagemenL
SusLalnable growLh ls Lhe level of growLh Lhe company can
malnLaln uslng lnLernally generaLed cash wlLhouL changlng
lLs caplLal sLrucLure
SusLalnable growLh raLe ls compuLed as
C* (sales/beglnnlng asseLs) (neL proflL/sales) (1+ debL/equlLy) 88
C* SusLalnable growLh raLe
88 Larnlng reLenLlon raLlo or neL lncome reLenLlon raLlo
usta|nab|e Growth
W SusLalnable growLh ls Lhe funcLlon of company's
1argeL debL equlLy raLlo
1argeL dlvldend pay ouL raLlo
roflL margln
AsseL Lurnover raLlo
1 rlzahmed llnanclal 8lsk ManagemenL
usta|nab|e growth
Lxample
W Sales 20000
W -eL proflL 4000
W ulvldend pollcy 10
W 1oLal asseLs 1000000
W uebL 00000
W LqulLy 00000
W CalculaLe 'C'
1 rlzahmed llnanclal 8lsk ManagemenL
usta|nab|e growth
Lxample
W Sales 20000
W -eL proflL 4000
W ulvldend pollcy 10
W 1oLal asseLs 1000000
W uebL 00000
W LqulLy 00000
W C (20/1000) x (4/20) x (1+00/00) x (110)
W
18 rlzahmed llnanclal 8lsk ManagemenL
usta|nab|e growth
1 rlzahmed llnanclal 8lsk ManagemenL
Long Lerm debL / solvency raLlo
Gear|ng rat|o LoLal debL/LoLal neL worLh
Leverage rat|o LoLal llablllLles / Langlble neL worLh
Interest coverage rat|on earnlng before lnLeresL Laxes/ lnLeresL expense
Debt serv|ce coverage rat|o earnlngs before lnL Laxes / (lnLeresL exp +
CL1u)
Debt kat|os
20 rlzahmed llnanclal 8lsk ManagemenL
lree cash flow cover L8l1uA MandaLory Capex / lnL exp +
CL1u
ulvldend payouL raLlo ulvldend / -eL lncome afLer Lax
lncome reLenLlon raLlo -lA1 ulvldend / -eL lncome afLer Lax
uebL Lo L8l1uA uebL / L8l1uA
Debt kat|os
21 rlzahmed llnanclal 8lsk ManagemenL
uslng Coloroll flnanclal sLaLemenLs on a consolldaLed basls
W CalculaLe Lhe relevanL flnanclal raLlos needed Lo make an assessmenL of
Lhe company's caplLal sLrucLure and gearlng raLlo
W Would you lend Lo Lhls company
C|ass Act|v|ty