CHAPTER IV

THE RISK ANALYSIS

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 OVERVIEW OF RISK ANALYSIS

- Risk is the potential of gaining or losing something of

value.
- Risk can also be defined as the intentional interaction
with uncertainty (potential, unpredictable and
uncontrollable outcome)

- Risk analysis covered:

• business risk
• financial risk
• insolvency risk

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 OVERVIEW OF RISK ANALYSIS

- Factors lead to enterprise’s risk:

• The changes in governmental policy, economic crisis

• The changes of market, customers’ behavior

• Natural disaster, the development of scientific and

technology
J4.1

3
 BUSINESS RISK ANALYSIS

• Definition: business risk is the risk coming along with

uncertainty, fluctuation in the company’s performance
and operating efficiency. The business performance and
operating efficiency are presented by indicators: sales,
profit, ROA, RE…

• Business risk assessment:

o Variance, standard deviation, coefficient of variation

o The degree of operating leverage/risk ratio

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 BUSINESS RISK ANALYSIS
Variance: The variance is one of the measures of dispersion, that is a measure of by
how much the values in the data set are likely to differ from the mean of the values

n
Var (k )   2   (k i  kˆ) 2 p i
i 1

n
kˆ   p i k i : expected value/mean of indicator : sales,
i 1
profit, ROS, ROA, ROE…
Ki : value of indicator
Pi : probability to get the value of indicator Ki
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 BUSINESS RISK ANALYSIS

Variance, standard deviation, coefficient of variation:

n
Var (k )   2
  (k i  k ) p i
ˆ 2

i 1

n
   i
(k 
i 1
ˆ) 2 p
k i


H bt 
kˆ

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 Illustration: ROAs of company A and B of the previous years are
shown in the following table. Compare business risk of two
companies using the dispersion of ROA (assumed that
probability to get the value of ROA in every quarter is the same)

Quarter I Quarter II Quarter III Quarter IV

ROA (Co A) 2 4 5 3
ROA (Co B) 21 20 25 18

Variance standard deviation coefficient of variation

Co A 3.5% 1,118 0,32
Co B 19.5% 1,118 0,057
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 BUSINESS RISK ANALYSIS

- The degree of operating leverage:

% change in operating profit Total CM

DOL = =
% change in sales Total CM - TFC

• Operating leverage is a measure of how revenue growth

translates into growth in operating income (measures the
sensitivity of a company's profit to fluctuations in its sales)
• The higher the degree of operating leverage, the more
volatile and unpredictable the EBIT figure is relative to a
given change in sales, assuming all other variables remain
constant.
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 BUSINESS RISK ANALYSIS

- The degree of operating leverage exposed some determinants of risk:

• The level of fixed costs

• The change of input cost and the ability of cost control
• The ability to adjust the selling price when the cost of input changes
• The change of market demand

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 BUSINESS RISK ANALYSIS

The impact of fixed cost on DOL might be mostly significant; it is related to the company’s
investment rate. DOL is also called as the fixed-cost leverage

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 BUSINESS RISK ANALYSIS

- Risk ratio:

Sales
Risk ratio =
Sales – break even sales

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 illustration

Co A Co B
Sales 200.000 200.000
Total variable cost 140.000 30.000
Contribution margin 60.000 170.000
Total fixed cost 30.000 140.000
Profit 30.000 30.000

The degree of operating leverage:

60.000 170.000
Co A:
30.000
= 2 Co B:
30.000
= 5,67

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 illustration

Scenario 1: sales increase by 20%

∆profit A =
∆ profit B =

Scenario 2: sales decrease by 20%

∆ profit A =
∆ profit B =

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 FINANCIAL RISK ANALYSIS

The degree of financial leverage (DFL)

% change in ROE
DFL =
% change in EBIT

The degree of financial leverage (DFL) measures the

sensitivity of a company's ROE to fluctuations in its
operating income, as a result of changes in its capital
structure

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 FINANCIAL RISK ANALYSIS

% change in ROE
DFL =
% change in EBIT

(EBIT – interest expense) (1 - T)

ROE = Owner’s equity

(∆EBIT - ∆ IE) (1 - T) ∆EBIT (1 - T)

∆ROE =
Owner’s equity
= Owner’s equity

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 FINANCIAL RISK ANALYSIS

∆EBIT (1 - T)
∆ROE ∆EBIT
Owner’s equity
= (EBIT - IE)(1 - T) =
ROE (EBIT - IE)
Owner’s equity

∆EBIT
P before tax +
EBIT
(EBIT - IE) interest expense
=
DFL = ∆EBIT =
(EBIT - IE) P before tax
EBIT 16
 INSOLVENCY RISK

• Short-term liquidity risk

• Long-term solvency risk
• Credit rating
• Altman Z-score – bankruptcy prediction model

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 INSOLVENCY RISK

• Liquidity refers to an enterprise's

ability to pay short-term
obligations.
• Solvency refers to an enterprise's
capacity to meet its long-term
financial commitments.
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 SHORT-TERM LIQUIDITY RISK

- Current liabilities coverage ratio

- Working capital turnover

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 SHORT-TERM LIQUIDITY RISK
- Current liabilities coverage ratio:
Current assets
Current ratio =
Current liabilities

Current assets – Inventories – other current assets

Quick ratio =
Current liabilities

Cash & cash equivalents

Cash ratio =
Current liabilities
Net cash flow from operations
Cash flow ratio =
Current liabilities
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 SOLVENCY RISK
- Working capital turnover:

Cost of goods sold

Inventory turnover = Average inventories
360
Inventory turnover period = Inventory turnover

Sales + VAT output

Accounts receivable
turnover = Average accounts receivable
360
Accounts receivable
= Accounts receivable
turnover period
turnover 21
 LONG-TERM SOLVENCY RISK

- Debt ratios
- Interest coverage ratios
- The ability to generate cash from operating
activities, investing activities and financing
activities

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 LONG-TERM SOLVENCY RISK
- Debt ratio:
Total liabilities
Liabilities to assets ratio =
Total assets

Total liabilities
Liabilities to shareholder’s
=
equity ratio Total shareholder’s equity
Long-term debt
Long-term debt to
long-term capital = Long-term debt + Total shareholder’s equity
ratio

Long-term debt
Long-term debt to
= 23
 LONG-TERM SOLVENCY RISK
- Interest coverage ratio

Profit before tax + interest expense

Interest
coverage =
ratio interest expense
Net cash flow from operations
= + payment for interest and income taxes
Cash payment for interest

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 CREDIT RATING

- A credit rating is an evaluation of the credit risk of a

prospective debtor, predicting their ability to pay back
the debt, and an implicit forecast of the likelihood of the
debtor defaulting.
+ Based on credit rating agencies (Moody, Standard and
Poor…..)
+ Altman z-score for predicting bankruptcy

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 CREDIT RATING
- Moody’s J4.2
- Fitch Ratings
- Standard and Poor’s
+ established in 1860, US
+ S&P 500, S&P Global 1200, S&P Vietnam 10

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J4.3

27
 ALTMAN Z-SCORE
- Bankruptcy prediction model : Edward I. Altman in 1968

- (born 1941) is a Professor of Finance,

Emeritus, at New York University’s Stern
School of Business
- Altman holds a B.A in Economics, (CCNY,
1963); an MBA ( UCLA, 1965); and
a Ph.D in finance (UCLA, 1967)
- Altman is the author, co-author, or editor of
25 books
- He was named one of the "100 Most
Influential People in Finance" by the Treasury
& Risk Management magazine in 2005 28
 ALTMAN Z-SCORE
- Bankruptcy prediction model :
For a public company:

Z = 1,2T1 + 1,4T2 + 3,3T3 + 0,6T4 + 1,0T5

T1= Net working capital/total assets (measure of liquidity)

T2= Retained earnings/total assets (measure of cumulative profitability)
T3= EBIT/total assets (measure of return on assets)
T4= market value of equity/book value of total liabilities (measure of
market leverage)
T5= Sales/total assets (measure of sales generating potential of assets )

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 ALTMAN Z-SCORE

- If Z > 2.99: “non-bankrupt sector”

- If 1,81<Z < 2.99: “gray area”

- If Z < 1.81: “bankrupt sector”

* Z” = 3,25 + 6,56X1 + 3,26X2 + 6,72X3 + 1,05X4

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 Z’’ adjustment S&P Moody’s

> 8,15 AAA Aaa

7,60 – 8,15 AA+ Aa1
7,30 – 7,60 AA Aa2
7,00 – 7,30 AA- Aa3
Safe area 6,85 – 7,00 A+ A1
Investable
6,65 – 6,85 A A2
6,40 – 6,65 A- A3
6,25 – 6,40 BBB+ Baa1
5,85 – 6,25 BBB Baa2
5,65 – 5,85 BBB- Baa3
5,25 – 5,65 BB+ Ba1
4,95 – 5,25 BB Ba2 High risk
Gray area
4,75 – 4,95 BB- Ba3
4,50 – 4,75 B+ B1
4,15 – 4,50 B B2
3,75 – 4,15 B- B3
3,20 – 3,75 CCC+ Caa1 Should not
invest
Dangerous area 2,50 – 3,20 CCC Caa2
1,75 – 2,50 CCC- Caa3

0 – 1,75 D
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 CASH FLOW BASED RATIOS

CFO
CFO to current liabilities =
Average current liabilities

CFO
CFO to total liabilities =
Average total liabilities

CFO + interest expense

CF-interest coverage =
interest expense

dividends
Dividend payout of cash from
=
operating activities CFO 32