KOLEJ UNIVERSITI TUNKU ABDUL RAHMAN

FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS

SEMESTER JAN 2021/2022
BBMF 4824 RISK MANAGEMENT
TUTORIAL 5 (WEEK 6)

1.Using the financial information below , determine the company’s stress

position in terms of corporate failure. Additional information includes
that the average share price for the period was RM1.40.

Total current assets (TCA) 1,182,000

Total non-current assets (TNCA) 1,700,000
Total assets (TA) 2,882,000
Total current liabilities (TCL) 736,000
Total non-current liabilities
883,000
(TNCL)
Total liabilities (TL) 1,619,000
Shareholders' equity (SE) 109,000
Retained earnings (RE) 1,154,000
Number of shares issued ( NSI) 100,000
Profit before tax (PBT) 245,000
Sales (S) 3,393,000
Inventory (1) 435,000

From the financial information given above, the Altman Z-score model is the best method to
calculate and determine the company's stress position in terms of corporate failure. It is a
statistical tool which is commonly used to measure the likelihood that a company will go
bankrupt.

The Z-score model indicates that if the score is below 1.8, it means the company is heading to
bankruptcy. If the score is above 3.0, the company is unlikely to go for bankruptcy.
𝑋1 = 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 −𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
= 1,182,000 −736,000 / 2,882,000
= 0. 155

𝑋2 = 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

= 1,154,000 / 2,882,000
= 0. 40

𝑋3 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥𝑒𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

= 245,000 / 2,882,000
= 0. 0850

𝑋4 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝐸𝑞𝑢𝑖𝑡𝑦 / 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

= 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 × 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 / 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
= 100,000 × 1.40 / 1,619,000
= 0.086

𝑋5 = 𝑆𝑎𝑙𝑒𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

= 3,393,000 / 2,882,000
= 1. 177

𝑍 = 1. 2𝑋1 + 1. 4𝑋2 + 3. 3𝑋3 + 0. 6𝑋4 + 1𝑋5

𝑍 = (1. 2× 0. 15) + (1. 4× 0. 40) + (3. 3× 0. 085) + (0. 6× 0. 086) + (1× 1. 18)
𝑍 = 2. 25

Z-score is 2.25. It falls in between 1.8 and 3.0 (Gray area). It should be considered a red flag
for possible problems. Hence, the company needs to monitor regularly to ensure that the
scores rise to 3.0 instead of falling to 1.8 in order to be healthy.

*Conclusion: The company has a Z-score of 2.255 which is below 3 and is very close to 1.8.
This indicates that the company is facing a risk of financial distress.
 2. Define inflation, currency and credit risk.

*Inflation risk: Inflation risk, also referred to as purchasing power risk, is the risk that
inflation will undermine the real value of cash flows made from an investment.
Inflation risk is especially impactful to fixed-income assets, such as bonds, as their fixed rate
of return becomes less valuable year after year with rising inflation. This is also true of
savings accounts, which typically do not pay enough interest to keep up with natural
inflation, let alone in a rising inflation environment.
For eg. you buy a bond with a coupon rate of 5% from RM500,000 government bonds, which
will pay annually RM25,000 income. If inflation is 3% annually, then RM25,000 income will
be reduce for next year. Thus next year income from the bond has an equivalent purchasing
power of RM24,250.

500,000
5%
25,000
3%
750
24,250

Financial risk is the uncertainty arising due to the use of debt finance in the capital structure
of the company. The firm, whose capital structure contains debt finance, are known as
levered firms whereas unlevered firms are the firms whereas capital structure is debt free.
Financial risk is the ability of a firm to pay off the debt it has taken from the bank or financial
institution. It will erode profitability and in the extreme case lead to business collapse.

*Credit risk: The possibility of losses due to failure to meet contractual obligations or pay
creditors on time. As a result, company may not get the credit terms from the lenders or
suppliers and make them loss trust to the company and affect the reputation as well. When
they loss trust, it will be difficult for the company to obtain funds and material needed for
production. Many factors can influence the credit risk and in varying degrees. For example,
poor or falling cash flow from operations, rising interest rates, or changes in the nature of the
marketplace that adversely affected such as a change in technology, an increase in
competitors, or regulatory changes.

Credit risk, or default risk, which arises from the inability of one party to fulfill its obligations
to another, such that they will be in default. Likewise, if a company is unable to collect its
receivables from customers, they will have poor cash inflow and lost income. Generally,
credit risk is associated with liquidity risk.
*Currency risk: Currency risk is the possibility of losing money due to adverse in exchange
rates. Investors or companies that have assets or business operations across national borders
are exposed to currency risk that may create unpredictable profits or losses. Currency risk can
be reduced by hedging, which offsets currency fluctuations. For example, Company A is a
Canadian company and pays interest and principal on a CA$1,000 bond with a 5% coupon. If
the exchange rate at the time of purchase is 1:1, then the 5% coupon payment is equal to
CA$50, and it is also equal to US$50. After a year, the exchange rate is 1:0.85. Now the
bond's 5% coupon payment, which is still CA$50, is worth only US$42.50. The investor has
loss a portion of his return because of the adverse in exchange rates.

1,000 1,000
5% 5%
$50.00 $50.00
$50.00 $42.50

Currency risk arises from the movements in foreign markets. Exchange rates of currencies
definitely have an impact on the earnings of a business with foreign operations or conduct
foreign transactions. For example, a Malaysia firm purchases raw materials from China and
settles in RMB. When RMB appreciates against MYR, the importer has to pay more for the
same amount of goods.
 3. Discuss the method to implement financial risk management.

*Develop good financial discipline and internal control

When effective internal control is in place, any errors or failure of financial system could be
discovered before they become big problems. Control activities should be communicated to
all stakeholders. With good financial discipline integrated throughout an organisation, it
would be able to conform well to its budget or financial plan set ahead, hence unintentional
errors or intentional fraud could be minimised.

The first method is developing good financial discipline and internal control. For example,
the company can set the standard and structures that provide the foundation for performing
internal control.

Develop concise reporting tools

The second method is developing concise reporting tools. For example, the company can
develop some reporting tools in many different ways to export data for further analysis.

*Prepare cash budget

A cash budget is a company's estimation of cash inflows and outflows over the specific
period of time. This budget is used whether the entity has sufficient cash to continue
operating. Cash budgets can be viewed as short-term cash budgets or long-term cash budget
which are by weekly, monthly, quarterly, and yearly basis. The cash budget provides a
company insight into its cash needs and helps to determine an efficient allocation of cash
while there have surplus in cash.

The third method is preparing a cash budget. For instance, a firm by preparing a cash budget
can plan the use of excess cash and make arrangements for the necessary cash as and when
required.

*Purchase credit insurance to cover non repayment of trade receivables

Firms tend to turn to trade credit insurance when they have a credit problem.
Trade credit insurance policy will reimburse the firm for a majority of the outstanding debt.
This helps protect firm's capital, maintain cash flow and secure earnings while extending
competitive credit terms and helping firm to access more attractive financing.
Potential recoveries from the default that cannot be predicted in advance. Thus the purchase
of the credit insurance is to have the cover protection against bad debts up to a max of 2
years.
To mitigate the credit risk of non-repayment by customers, upon borrowing of funds,
customer should pledge a collateral as guarantees of their borrowings. Firm must have the
capability to negotiate with the borrower by giving them several options for payment of debts
arrangements.
Company should also have funds available if there is any, to pay the debt after the repayment
of others.
The fourth method is purchase credit insurance to cover non repayment of trade receivables.
For example, if 20 percent of customers make up 80 percent of total sales, it may be wise to
have a credit insurance policy in place because the risk of loss from just one customer is so
great, firm might not be able to recover from it.

*Monitor the change of interest rate, inflation rate and foreign currency exchange rate
This is one of the mitigation to prevent foreign exchanged risk, the risk is associated with the
fluctuations in currency values. It happens when a financial transaction is denominated in a
currency other than the base currency of the business. For example, a company that is based
in Malaysia has clients in the USA and earns the majority of revenue in USD. This company
faces a foreign exchange risk as the revenues need to be converted from USD to RM, and is
exposed to exchange rate fluctuations between the two currencies. (financial market unstable)

The fifth method is monitoring the change of interest rate, inflation rate and foreign currency
exchange rate. This is because exchange rates, interest rates and inflation rates are all
interconnected. For instance, an increase in interest rates causes a country’s currency to
appreciate, as lenders are provided with higher rates and thereby attracting more foreign
capital. This can cause a rise in the value of a currency and therefore the exchange rate.
 4. Discuss any three qualitative factors that predict corporate failures with
examples.

i. Poor organisation culture

Culture of the organisation could affect the efficiencies and effectiveness of employees. For
example, a working environment involves high level of office politics would separate
employees into different parties, they cannot be united and are hard to cooperate with other
parties.

ii. Failure to keep up to date

- This can be defined as the company fail to develop new product to meet the demand of
customers.
For example, the technologically oriented business need to always ensure that they have
proper innovation in place and conduct research and development from time to time.

iii. Inability to obtain financing.

- The company's financial trends can cause this issue to be arrised. The deteriotion of fearing
ratio, liquidity and profitability can make the organisation difficult to obtain financing.
Without adequate finance some businesses may find it hard to cope with increased demand,
and the extra pressures on their cash flow can lead to breaking point. For an example, the
higher gearing ratio will breach the debt covenant which may cause the difficulty to obtain
additional finance from the existing loan provider.

iv. Inability to respond to changes

- Especially social changes like nowadays the way of people interacting is very different from
the past. For example, businesses without social media platform like Facebook or email are
difficult to interact with their customers, also, the restaurant without delivering services has
loss most of the sales, they are unable to meet the needs of the people

The first qualitative factor is decline in industry. An industry is said to be in decline when it
does not keep pace with the rest of the country's economic growth. For instance, the market
capital of a company is usually more than 50%. However, market capital decreases to 10%
due to a lot of competition.

Another qualitative factor is poor management quality. In the management category, 70% of
businesses failed due to owners not recognising their failings and not seeking help. Hiring the
wrong people were additional major contributing factors to business failure in this category.
For example, 1MDB has a poor leadership that leads the company to money laundering.

The following qualitative factor is inability to obtain financing. The company would have
been facing accounting deficiencies. For example, banks refuse to lend money to the
company for the reason that the company is not making profit or a bad reputation of the
company.
 5. Discuss how risk impact on the market value of a firm?

*Learning to manage risks effectively enables managers to make better of the outcomes by
identifying and analysing the range of issues, and providing a systematic way to make
decisions well informed. The more risk associated with an investment to the company, the
more higher return can fulfil the demand of the firm.

Risk also able to create value contributing as an early warning system that positions to the
firms, to make adjustments on the firm's market value and strategy. Well managed risks can
assist the firm capitalise on market opportunities and emerging risks.

For example, a firm faces financial risk such as strict credit term that increase interest rate or
limit loan amount to finance the operation. This would affect the market value of the firm that
erode the profitability and may bring about business collapse. Therefore, risk management is
important for manager to identify issues and provide systematic way to make informed
decisions.

The company's exposure to risks will directly affect the value of the firm. When the risk
increases, the market value of the firm decreases. For instance, when the company’s ability in
collecting its receivable from their customers is poor, they will have poor cash inflow and lost
income. If the company faces shortage of cash, it possibly will lead to other extreme
problems as well. This is due to cash being considered as a most important asset for a
company. The investor’s confidence towards the firm will be diminished. Hence, the
investors will sell their shares, indirectly decreasing the market value of the firm.

suffer losses, EPS low, impact on the share prices.