risk analysis: an extended look dr. nancy mangold california state university, east bay
TRANSCRIPT
Risk Analysis: An Extended Risk Analysis: An Extended LookLook
Dr. Nancy MangoldDr. Nancy Mangold
California State University, California State University, East BayEast Bay
Credit RiskCredit Risk
A firm’s ability to make interest A firm’s ability to make interest and principal payments on and principal payments on borrowingsborrowings
Bankruptcy RiskBankruptcy Risk
The likelihood that a firm will file The likelihood that a firm will file for bankruptcy and perhaps for bankruptcy and perhaps subsequently liquidatesubsequently liquidate
Financial distress Financial distress continuumcontinuum
Failing to make a required interest Failing to make a required interest payment on timepayment on time
defaulting on a principal payment defaulting on a principal payment on debton debt
filing for bankruptcyfiling for bankruptcy liquidating a firmliquidating a firm
Financial DistressFinancial Distress
Analysts concerned with the Analysts concerned with the economic loss of a portion or all of economic loss of a portion or all of the amount lent to or invested in a the amount lent to or invested in a firm can examine a firm’s position firm can examine a firm’s position on this financial distress on this financial distress continuum.continuum.
Broader definition of riskBroader definition of risk
To explain the differences in To explain the differences in market rates of return of common market rates of return of common stocksstocks
Economic theory holds that the Economic theory holds that the differences in market return must differences in market return must relate to differences in perceived relate to differences in perceived riskrisk
Risk measure :Risk measure :Market equity betaMarket equity beta
Market equity beta used as the Market equity beta used as the measure of riskmeasure of risk
Market equity beta measures the Market equity beta measures the covariability of a firm’s returns covariability of a firm’s returns with the returns of all securities in with the returns of all securities in the marketthe market
Sources of Debt Financing:Sources of Debt Financing:Commercial BanksCommercial Banks
Commercial banks lend funds to firms to Commercial banks lend funds to firms to financefinance• working capital needsworking capital needs• accounts receivableaccounts receivable• inventoryinventory
Accounts receivable and inventory serve Accounts receivable and inventory serve as collateralas collateral
Usually short-term: less than one yearUsually short-term: less than one year Appear in Current liabilities - notes payableAppear in Current liabilities - notes payable
Sources of Debt Financing:Sources of Debt Financing:Commercial BanksCommercial Banks
Commercial banks also provide funds to Commercial banks also provide funds to purchase equipment, buildings, and purchase equipment, buildings, and other long-term assetsother long-term assets
These loans extend for periods of 20 or These loans extend for periods of 20 or more yearsmore years
Specific assets financed used as a Specific assets financed used as a collateralcollateral
appear in the long-term debt payable appear in the long-term debt payable categorycategory
Sources of Debt Financing:Sources of Debt Financing:Other Financial InstitutionsOther Financial Institutions
Firms may also obtain funds fromFirms may also obtain funds from• Insurance companiesInsurance companies• finance companiesfinance companies• other financial institutionsother financial institutions
Finance long-term assetsFinance long-term assets Assets serve as collateral for the Assets serve as collateral for the
borrowingborrowing
Sources of Debt Financing:Sources of Debt Financing:Commercial paper MarketCommercial paper Market
Firms issue commercial paper for Firms issue commercial paper for very short-term needs for cashvery short-term needs for cash• meet payroll before collecting cash meet payroll before collecting cash
from accounts receivable monthly from accounts receivable monthly UnsecuredUnsecured Included in notes payable- current Included in notes payable- current
liabilitiesliabilities
Sources of Debt Financing:Sources of Debt Financing:Commercial paper MarketCommercial paper Market
Large established firms with solid Large established firms with solid credit status most easily access credit status most easily access the commercial paper market for the commercial paper market for fundsfunds
Lenders in the commercial paperLenders in the commercial paper• financial institutionsfinancial institutions• business enterprises with excess cashbusiness enterprises with excess cash• money market mutual fundsmoney market mutual funds
Sources of Debt Financing:Sources of Debt Financing:Unsecured Debt MarketUnsecured Debt Market
Firms needing long-term sources of Firms needing long-term sources of funds can issue bonds on the open funds can issue bonds on the open marketmarket
Bonds are unsecuredBonds are unsecured Priced according toPriced according to
• the overall credit quality of the issuerthe overall credit quality of the issuer• the term to maturity of the bondsthe term to maturity of the bonds• the general level of interest rates in the the general level of interest rates in the
marketmarket
Sources of Debt Financing:Sources of Debt Financing:Unsecured Debt MarketUnsecured Debt Market
In BankruptcyIn Bankruptcy• First: secured (collateralized lendersFirst: secured (collateralized lenders• second: bonds holders second: bonds holders • third: preferred stockholdrsthird: preferred stockholdrs• last: common stockholderslast: common stockholders
Long term debt payable on balance Long term debt payable on balance sheetsheet
investors: financial institutions, mutual investors: financial institutions, mutual funds, pension funds and individualsfunds, pension funds and individuals
Sources of Debt Financing:Sources of Debt Financing:SuppliersSuppliers
Suppliers of various goods and Suppliers of various goods and services that do not require firms to services that do not require firms to pay immediately implicitly provide pay immediately implicitly provide funds to the firmfunds to the firm
Suppliers of raw materials or Suppliers of raw materials or merchandise inventories may merchandise inventories may require that the inventories serve as require that the inventories serve as collateral for the delayed paymentcollateral for the delayed payment
Credit Risk AnalysisCredit Risk Analysis
Circumstances leading to need for the Circumstances leading to need for the loanloan
Cash FlowsCash Flows CollateralCollateral Capacity for DebtCapacity for Debt ContingenciesContingencies Character of ManagementCharacter of Management ConditionsConditions
Circumstances leading to Circumstances leading to need for the loanneed for the loan
The reason that a firm needs to The reason that a firm needs to borrow affects the riskiness of the borrow affects the riskiness of the loan and the likelihood of loan and the likelihood of repaymentrepayment
W.T. Grant CompanyW.T. Grant Company
Discount retail chain filed for Discount retail chain filed for bankruptcy in 1975bankruptcy in 1975
Between 1968 and 1975 Grant Between 1968 and 1975 Grant experienced increasing difficulty experienced increasing difficulty collecting accounts receivables.collecting accounts receivables.
Borrow short-term funds from Borrow short-term funds from commercial banks to finance the commercial banks to finance the buildup of its accounts receivablebuildup of its accounts receivable
W.T. Grant CompanyW.T. Grant Company
Lending to satisfy cash flow needs Lending to satisfy cash flow needs related to an unsolved problem or related to an unsolved problem or difficulty can be highly riskydifficulty can be highly risky
Toys “R” Us Toys “R” Us
Purchases toys, games, and other Purchases toys, games, and other entertainment products in September entertainment products in September and October in anticipation of heavy and October in anticipation of heavy demand during the end-of-the year demand during the end-of-the year holiday seasonholiday season
Typically pays its suppliers within 30 Typically pays its suppliers within 30 days for these purchases, but doesn’t days for these purchases, but doesn’t collect cash from customers until collect cash from customers until December, January or laterDecember, January or later
Toys “R” UsToys “R” Us
Borrow short term funds from its banks to Borrow short term funds from its banks to finance its inventoryfinance its inventory
Repays these loans with cash collected from Repays these loans with cash collected from customerscustomers
Lending to satisfy cash flow needs related to Lending to satisfy cash flow needs related to ongoing seasonal business operations is ongoing seasonal business operations is generally relatively low riskgenerally relatively low risk
Toys “R” Us has an established brand name Toys “R” Us has an established brand name and predictable demand and diverse product and predictable demand and diverse product lineline
Wal-Mart StoresWal-Mart Stores
Grows the number of its stores at a rate Grows the number of its stores at a rate of 12% per year during the last five of 12% per year during the last five yearsyears
The fastest growth is in its superstores ( The fastest growth is in its superstores ( a combination of its traditional discount a combination of its traditional discount store and a grocery store).store and a grocery store).
Borrows a large portion of the funds Borrows a large portion of the funds needed to construct new stores using needed to construct new stores using 20- to 25-year loans20- to 25-year loans
Wal-Mart StoresWal-Mart Stores
Also enters into leases for a Also enters into leases for a significant portion of the space significant portion of the space needed for its new storesneeded for its new stores
Such loans are relatively low risk Such loans are relatively low risk • given Wal-Mart’s operating success in given Wal-Mart’s operating success in
the pastthe past• the land and buildings that serve as the land and buildings that serve as
collateral for the loanscollateral for the loans
Data General CorporationData General Corporation
mMaintained a presence in the mMaintained a presence in the midsize computer market for midsize computer market for several decadesseveral decades
Technological advances and Technological advances and aggressive marketing by aggressive marketing by competitors have eroded its share competitors have eroded its share of the computer market .of the computer market .
Data General CorporationData General Corporation
Wanted to develop new Wanted to develop new technologies for internet productstechnologies for internet products
Needed to borrow funds to finance Needed to borrow funds to finance its research and development its research and development efforteffort
Data General CorporationData General Corporation
Such a loan would be relatively Such a loan would be relatively high-riskhigh-risk• embarking on a new line of business embarking on a new line of business
for which it does not necessarily have for which it does not necessarily have a competitive advantagea competitive advantage
• rapid technology changerapid technology change• R&D expenditures may not result in R&D expenditures may not result in
assets that can be serve as collateral assets that can be serve as collateral for the loanfor the loan
Lower credit riskLower credit risk
Lending to established firms for Lending to established firms for ongoing operating needs ongoing operating needs
Higher credit risksHigher credit risks
Lending to firms experiencing Lending to firms experiencing operating problemsoperating problems
Lending to emerging businesses Lending to emerging businesses Lending to support investments in Lending to support investments in
intangible assets typically carry intangible assets typically carry higher riskshigher risks
Cash FlowsCash Flows
Lenders want firms to generate Lenders want firms to generate sufficient cash flow to pay interest sufficient cash flow to pay interest and repay principal on a loan so and repay principal on a loan so they don’t have to rely on selling they don’t have to rely on selling the collateralthe collateral
Cash FlowsCash Flows
Tools for studying the cash-Tools for studying the cash-generating ability of a firmgenerating ability of a firm• examination of the statement of cash examination of the statement of cash
flows for recent yearsflows for recent years• computation of various cash flow-computation of various cash flow-
based financial ratiosbased financial ratios• study of projected financial study of projected financial
statementsstatements
Statement of Cash FlowsStatement of Cash Flows
Indicators of potential cash flow Indicators of potential cash flow problems if observed for several problems if observed for several years in a rowyears in a row
Growth in accounts receivable or Growth in accounts receivable or inventories that exceeds the inventories that exceeds the growth rate in salesgrowth rate in sales
Increases in accounts payable that Increases in accounts payable that exceed the increase in inventoriesexceed the increase in inventories
Indicators of potential Indicators of potential cash flow problemscash flow problems
Other current liabilities that grow Other current liabilities that grow at a faster rate than salesat a faster rate than sales
Persistent negative cash flow from Persistent negative cash flow from operations because of net losses or operations because of net losses or substantial increases in net substantial increases in net working capitalworking capital
Indicators of potential Indicators of potential cash flow problemscash flow problems
Capital expenditures that Capital expenditures that substantially exceed cash flow from substantially exceed cash flow from operationsoperations• indicates a firm’s continuing need for indicates a firm’s continuing need for
external financing to sustain growthexternal financing to sustain growth Reductions in capital expenditures Reductions in capital expenditures
over timeover time• signal declines in future sales, earnings, signal declines in future sales, earnings,
and operating cash flowsand operating cash flows
Indicators of potential Indicators of potential cash flow problemscash flow problems
Sales of marketable securities in Sales of marketable securities in excess of purchases of marketable excess of purchases of marketable securitiessecurities• signal the inability of a firm’s signal the inability of a firm’s
operations to provide adequate cash operations to provide adequate cash flow to finance working capital and flow to finance working capital and long-term investmentslong-term investments
Indicators of potential Indicators of potential cash flow problemscash flow problems
A substantial shift from long-term A substantial shift from long-term borrowing to short-term borrowingborrowing to short-term borrowing• signal a firm’s inability to obtain long-signal a firm’s inability to obtain long-
term loans because lenders are term loans because lenders are uncertain about a firm’s futureuncertain about a firm’s future
A reduction or elimination of dividend A reduction or elimination of dividend paymentspayments• a negative signal about a firm’s future a negative signal about a firm’s future
prospectsprospects
Cash Flow Financial RatiosCash Flow Financial Ratios
Cash Flow from operations Cash Flow from operations
Average Current liabilitiesAverage Current liabilities
Indicates the ability of a firm to Indicates the ability of a firm to generate sufficient cash flows from generate sufficient cash flows from operations to repay liabilities operations to repay liabilities coming due with the next yearcoming due with the next year
Cash Flow Financial RatiosCash Flow Financial Ratios
Cash flow from operationsCash flow from operations
Average Total LiabilitiesAverage Total Liabilities
IndicatesIndicates a firm’s ability to a firm’s ability to generate sufficient cash flow to generate sufficient cash flow to repay all liabilitiesrepay all liabilities
Cash Flow Financial RatiosCash Flow Financial Ratios
Cash flow from operations Cash flow from operations
Capital ExpendituresCapital Expenditures Indicates the ability of a firm to finance Indicates the ability of a firm to finance
capital expenditures with operating capital expenditures with operating cash flowscash flows
<1 indicates a will need to continue to <1 indicates a will need to continue to find various sources of capital to finance find various sources of capital to finance capital expenditures to continue its capital expenditures to continue its growthgrowth
Projected Financial Projected Financial StatementsStatements
Projected financial statements , Projected financial statements , Pro Pro Forma Forma financial statements represent financial statements represent forecasted income statements, balance forecasted income statements, balance sheets, and statements of cash flows for sheets, and statements of cash flows for some number of years into the futuresome number of years into the future
Lenders require potential borrowers to Lenders require potential borrowers to prepare such statements to demonstrate prepare such statements to demonstrate the borrower’s ability to repay the loan the borrower’s ability to repay the loan with interest as it comes duewith interest as it comes due
Projected Financial Projected Financial StatementsStatements
The credit analyst should question each The credit analyst should question each of the important assumptions underlying of the important assumptions underlying these projected financial statementsthese projected financial statements• sales growthsales growth• cost structurecost structure• capital expenditure planscapital expenditure plans
Should also assess the sensitivity of the Should also assess the sensitivity of the projected cash flows to change sin key projected cash flows to change sin key assumptionsassumptions
CollateralCollateral
The availability and value of The availability and value of collateral for a loancollateral for a loan
If cash flows are insufficient to pay If cash flows are insufficient to pay interest and repay the principal on interest and repay the principal on a loan, the lender has the right to a loan, the lender has the right to obtain any collateral pledged in obtain any collateral pledged in support of the loansupport of the loan
CollateralCollateral
Marketable Securities reported at Marketable Securities reported at at market value on balance sheet at market value on balance sheet (< 20% ownership)(< 20% ownership)
Assess whether the market value Assess whether the market value of securities pledged as collateral of securities pledged as collateral exceeds the unpaid balance of a exceeds the unpaid balance of a loanloan
CollateralCollateral
Accounts ReceivableAccounts Receivable Assess whether the current value Assess whether the current value
of accounts receivable is sufficient of accounts receivable is sufficient to cover the unpaid portion of a to cover the unpaid portion of a loan collateralized by accounts loan collateralized by accounts receivablereceivable
CollateralCollateral
ExamineExamine• changes in provision for uncollectible changes in provision for uncollectible
accounts relative to salesaccounts relative to sales• the balance in allowance for uncollectible the balance in allowance for uncollectible
accounts relative to gross accounts receivableaccounts relative to gross accounts receivable• the amount of accounts written off as the amount of accounts written off as
uncollectible relative to gross accounts uncollectible relative to gross accounts receivablereceivable
• the number of days receivables are the number of days receivables are outstandingoutstanding
InventoriesInventories
ExamineExamine• Changes in inventory turnover rateChanges in inventory turnover rate• Cost of goods sold to sales Cost of goods sold to sales
percentagepercentage• Mix of raw materials, work in process Mix of raw materials, work in process
inventories, and finished goods inventories, and finished goods inventories to identify possible inventories to identify possible inventory obsolescence problemsinventory obsolescence problems
InventoriesInventories
LIFO inventories market value exceed LIFO inventories market value exceed the book valuethe book value
FIFO inventories will be closer to market FIFO inventories will be closer to market valuevalue
Using footnotes on the excess of market Using footnotes on the excess of market or FIFO value over LIFO cost permit the or FIFO value over LIFO cost permit the analyst to assess the adequacy of LIFO analyst to assess the adequacy of LIFO inventories to cover the unpaid balance inventories to cover the unpaid balance on a loan collateralized by inventorieson a loan collateralized by inventories
Property, Plant and Property, Plant and EquipmentEquipment
Fixed assets as collateral for long-term Fixed assets as collateral for long-term borrowingborrowing
Determining the market values of such Determining the market values of such assets is difficult using reported assets is difficult using reported financial statement information because financial statement information because the use of historical cost valuationsthe use of historical cost valuations
Market values of unique, firm-specific Market values of unique, firm-specific assets are particularly difficult to assets are particularly difficult to ascertain.ascertain.
Property, Plant and Property, Plant and EquipmentEquipment
Clues indicating market value Clues indicating market value declines include declines include • restructuring chargesrestructuring charges• asset impairment charges related to asset impairment charges related to
such assetssuch assets• recent sales at a lossrecent sales at a loss
Nonsecured lendingNonsecured lending
Study the notes to the financial Study the notes to the financial statements to ascertain how much statements to ascertain how much of the borrower’s assets are not of the borrower’s assets are not already pledged or restrictedalready pledged or restricted
The liquidation value of such The liquidation value of such assets represents the available assets represents the available resources of a firm to repay resources of a firm to repay unsecured creditorsunsecured creditors
Nonsecured lendingNonsecured lending
For small business, additional For small business, additional source of collateral may besource of collateral may be• personal assets of management or personal assets of management or
major shareholdersmajor shareholders
Capacity for DebtCapacity for Debt
A firm’s capacity to assume additional A firm’s capacity to assume additional debtdebt
A firm’s cash flows and collateral A firm’s cash flows and collateral represent the means to repay the debtrepresent the means to repay the debt
Most firms do not borrow up to the limit Most firms do not borrow up to the limit of their debt capacityof their debt capacity
Lenders want to make sure that a Lenders want to make sure that a margin of safety existsmargin of safety exists
Capacity for Debt:Capacity for Debt:Debt RatiosDebt Ratios
long-term debt ( total liabilities )long-term debt ( total liabilities )
/ total assets/ total assets long-term debt ( total liabilities ) long-term debt ( total liabilities )
/shareholders’ equity/shareholders’ equity consider off-balance sheet obligationsconsider off-balance sheet obligations
• operating lease commitmentsoperating lease commitments• underfunded pensionunderfunded pension• health care benefit obligationhealth care benefit obligation
Capacity for Debt:Capacity for Debt:Debt RatiosDebt Ratios
The higher the debt ratiosThe higher the debt ratios The higher the credit riskThe higher the credit risk The lower the unused debt The lower the unused debt
capacity of the firmcapacity of the firm
Capacity for Debt:Capacity for Debt:Interest Coverage RatioInterest Coverage Ratio
Operating income before interest Operating income before interest and taxes / interest paymentsand taxes / interest payments
A measure of margin of safety A measure of margin of safety provided by operations to service provided by operations to service debtdebt
Capacity for Debt:Capacity for Debt:Interest Coverage RatioInterest Coverage Ratio
When firms make heavy use of When firms make heavy use of operating leases for their fixed assets, operating leases for their fixed assets, the analyst might convert the operating the analyst might convert the operating leases to capital leases for the purpose leases to capital leases for the purpose of computing the interest coverage ratioof computing the interest coverage ratio
add back the lease payments to net add back the lease payments to net incomeincome
include the lease payments in the include the lease payments in the denominatordenominator
Capacity for Debt:Capacity for Debt:Interest Coverage RatioInterest Coverage Ratio
<2 high credit risk<2 high credit risk > 4 capacity to carry additional > 4 capacity to carry additional
debtdebt
ContingenciesContingencies
Is the firm a defendant in a major Is the firm a defendant in a major lawsuit involving its principal productslawsuit involving its principal products
Negative legal judgments will likely Negative legal judgments will likely have a more pronounced effect on have a more pronounced effect on smaller firmssmaller firms• less resource to defend themselvesless resource to defend themselves• less resource to sustain such lossesless resource to sustain such losses• may not carry adequate insurancemay not carry adequate insurance
ContingenciesContingencies
Has the firm served as guarantor Has the firm served as guarantor on a loan by a subsidiary, joint on a loan by a subsidiary, joint venture, or corporate officerventure, or corporate officer
ContingenciesContingencies
Has the firm committed itself to Has the firm committed itself to make payments related to make payments related to derivative financial instruments derivative financial instruments that could adversely affect future that could adversely affect future cash flows if interest rate, cash flows if interest rate, exchange rates or other prices exchange rates or other prices change significantly in an change significantly in an unexpected direction?unexpected direction?
ContingenciesContingencies
Is the firm dependent on one or a Is the firm dependent on one or a few few • key employees, key employees, • contracts contracts • license agreements, orlicense agreements, or• technologies technologies
whose loss could substantially whose loss could substantially affect the viability of the business?affect the viability of the business?
ContingenciesContingencies
Examine notes to the financial Examine notes to the financial statementsstatements
Ask questions of management, Ask questions of management, attorneys and others.attorneys and others.
Character of ManagementCharacter of Management
Has the management team Has the management team successfully weathered previous successfully weathered previous operating problems and challenges operating problems and challenges that could have bankrupted most that could have bankrupted most firms?firms?
Character of ManagementCharacter of Management
Has the management team Has the management team delivered in the past on projections delivered in the past on projections made with regard tomade with regard to• sales levelsales level• cost reductionscost reductions• new product developmentnew product development• other operating targetsother operating targets
Character of ManagementCharacter of Management
Does the firm have a reputation for Does the firm have a reputation for honest and fair dealings with suppliers, honest and fair dealings with suppliers, customers, bankers, and others?customers, bankers, and others?
Do managers have a substantial Do managers have a substantial portion of their personal wealth portion of their personal wealth invested in the firm’s common equityinvested in the firm’s common equity• managers have incentives to operate the managers have incentives to operate the
firm profitably and avoid defaulting on debt firm profitably and avoid defaulting on debt to increse the value of their equity holdingto increse the value of their equity holding
ConditionsConditions
Lenders often place restrictions or Lenders often place restrictions or constraints on a firm to protect their constraints on a firm to protect their interestsinterests• Minimum level of certain financial ratios Minimum level of certain financial ratios
(current ratio > 1.2))(current ratio > 1.2))• maximum level of certain financial ratios maximum level of certain financial ratios
(debt/equity ratio < 75%)(debt/equity ratio < 75%)• Restrictions on paying dividendsRestrictions on paying dividends• Limit on new financingLimit on new financing
ConditionsConditions
Debt covenants can protect the Debt covenants can protect the interest of senior, collateralized lendersinterest of senior, collateralized lenders• protection again undue deterioration in the protection again undue deterioration in the
financial condition of a firmfinancial condition of a firm They can place less senior lenders in They can place less senior lenders in
jeopardy if the firm must quickly jeopardy if the firm must quickly liquidate assets to repay debtliquidate assets to repay debt• increase the likelihood of default or increase the likelihood of default or
bankruptcy if the constraints are too tightbankruptcy if the constraints are too tight
The Bankruptcy ProcessThe Bankruptcy Process
firms may file under Chapter XI of firms may file under Chapter XI of the National Bankruptcy Codethe National Bankruptcy Code
Firms have four months to present Firms have four months to present a plan of reorganization to the a plan of reorganization to the courtcourt
After four months, creditors, After four months, creditors, employees and others can file their employees and others can file their plans of reorganizationplans of reorganization
The Bankruptcy ProcessThe Bankruptcy Process
The court decides which plan The court decides which plan provides the fairest treatment for provides the fairest treatment for all parties concernedall parties concerned
When the court determines that When the court determines that the firm has executed the plan of the firm has executed the plan of reorganization successfully and reorganization successfully and appears to be viable entity, the appears to be viable entity, the firm is released from bankruptcyfirm is released from bankruptcy
The Bankruptcy ProcessThe Bankruptcy Process
A Chapter XII filing for bankruptcy A Chapter XII filing for bankruptcy entails an immediate sale or entails an immediate sale or liquidation of the firm’s assets and liquidation of the firm’s assets and a distribution of the proceeds to a distribution of the proceeds to the various claimants in the order the various claimants in the order of their priority.of their priority.
Models of Bankruptcy Models of Bankruptcy PredictionPrediction
Univariate Bankruptc;y Prediction Univariate Bankruptc;y Prediction Models examine the relation Models examine the relation between a particular financial between a particular financial statement ratio and bankruptcystatement ratio and bankruptcy
Univariate Bankruptcy Univariate Bankruptcy Prediction ModelsPrediction Models
Beaver studied 29 financial Beaver studied 29 financial statement ratios for the five years statement ratios for the five years preceding bankruptcy for a sample preceding bankruptcy for a sample of bankrupt and non-bankrupt of bankrupt and non-bankrupt firmsfirms
Univariate Bankruptcy Univariate Bankruptcy Prediction ModelsPrediction Models
The six ratios with the best The six ratios with the best discriminating power arediscriminating power are
(long-term solvency risk(long-term solvency risk• NI before depreciation, depletion and NI before depreciation, depletion and
amortization/ Total Liabilitiesamortization/ Total Liabilities ProfitabilityProfitability
• NI/Total AssetsNI/Total Assets
Univariate Bankruptcy Univariate Bankruptcy Prediction ModelsPrediction Models
Long-term solvency riskLong-term solvency risk• Total Debt/ Total AssetsTotal Debt/ Total Assets
Short-term liquidity riskShort-term liquidity risk• Net working capital/Total AssetsNet working capital/Total Assets
Short-term liquidity riskShort-term liquidity risk• Current Assets/ Current LiabilitiesCurrent Assets/ Current Liabilities
Short-term liquidity riskShort-term liquidity risk• Cash, marketable securities, accounts Cash, marketable securities, accounts
receivable/operating expensesreceivable/operating expenses
Multivariate Bankruptcy Multivariate Bankruptcy Prediction ModelsPrediction Models
Multiple Discriminant Analysis Multiple Discriminant Analysis (MDA)(MDA)
The best-known MDA bankruptcy The best-known MDA bankruptcy prediction model is Altman’s Z-prediction model is Altman’s Z-scorescore
Altmans Bankruptcy Altmans Bankruptcy Prediction Model Prediction Model
Z = 1.2(NWC/TA)+ 1.4(RE/TA)+ Z = 1.2(NWC/TA)+ 1.4(RE/TA)+ 3.3(EBIT/TA) + .6(MV-EQ/BV-Liab)+ 3.3(EBIT/TA) + .6(MV-EQ/BV-Liab)+ 1.0(S/TA)1.0(S/TA)
MWC/TA1:(current assets - current MWC/TA1:(current assets - current liabilities)/total assetsliabilities)/total assets
measure the proportion of total assets measure the proportion of total assets representing relatively liquid net current representing relatively liquid net current assets (ST liquidity risk)assets (ST liquidity risk)
Altman’s Bankruptcy Altman’s Bankruptcy Prediction ModelPrediction Model
RE/TA: retained earnings / total RE/TA: retained earnings / total assetsassets
measures accumulated profitability measures accumulated profitability and relative age of a firmand relative age of a firm
EBIT/TA: EBIT / total assetsEBIT/TA: EBIT / total assets measures current profitabilitymeasures current profitability
Altman’s Bankruptcy Altman’s Bankruptcy Prediction Model Prediction Model
MV-EQ/BV-Liab: market value of MV-EQ/BV-Liab: market value of preferred and common equity / preferred and common equity / book value of total liabilitiesbook value of total liabilities
market’s overall assessment of the market’s overall assessment of the profitability and risk of the firmprofitability and risk of the firm
S/TA: sales / total assetsS/TA: sales / total assets measures ability of a firm to use measures ability of a firm to use
assets to generate salesassets to generate sales
Altman’s Bankruptcy Altman’s Bankruptcy Prediction ModelPrediction Model
If Z > 2.99 assign to nonbankrupt If Z > 2.99 assign to nonbankrupt group, low probability of group, low probability of bankruptcybankruptcy
If Z < 1.81 assign to bankrupt If Z < 1.81 assign to bankrupt group, higher probability of group, higher probability of bankruptcybankruptcy
1.81 < Z < 2.99 gray area1.81 < Z < 2.99 gray area
Multivariate Bankruptcy Multivariate Bankruptcy Prediction ModelsPrediction Models
James Ohlson used Logit Analysis James Ohlson used Logit Analysis to discriminate bankrupt from non-to discriminate bankrupt from non-bankrupt firmsbankrupt firms
y=-1.32 - 0.407(SIZE) + y=-1.32 - 0.407(SIZE) + 6.03(TLTA) - 1.43(WCTA) + 6.03(TLTA) - 1.43(WCTA) + 0.0757(CLCA) - 2.37)NITA) - 0.0757(CLCA) - 2.37)NITA) -
1.83 (FUTL) + 0.285 (INTWO) - 1.83 (FUTL) + 0.285 (INTWO) - 1.72 (OENEG) - 0.521 (CHIN)1.72 (OENEG) - 0.521 (CHIN)
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
Size: larger firms have greater Size: larger firms have greater flexibility to curtail capacity, sell flexibility to curtail capacity, sell assets, and attract debt or equity assets, and attract debt or equity capital than smaller firmscapital than smaller firms
TLTA (Total Liabilities/ Total Assets) :TLTA (Total Liabilities/ Total Assets) :• Long-term solvency riskLong-term solvency risk• Higher debt ratios increase the Higher debt ratios increase the
probability of bankruptcyprobability of bankruptcy
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
WCTA (Working capital/Total WCTA (Working capital/Total Assets:Assets:• the higher the proportion of net the higher the proportion of net
working capital to total assets, working capital to total assets, • the more liquid are the assetsthe more liquid are the assets• the lower the probability of the lower the probability of
bankruptcybankruptcy
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
CLCA (Current Liabilities/Current CLCA (Current Liabilities/Current Assets):Assets):• An excess of current liabilities over An excess of current liabilities over
current assets is also an indicator of current assets is also an indicator of short-term liquidity riskshort-term liquidity risk
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
NITA (Net Income/Total Assets):NITA (Net Income/Total Assets):• the higher the rate of profitability,the higher the rate of profitability,• the less likely a firm will experience the less likely a firm will experience
difficulty servicing debtdifficulty servicing debt• the lower the probability of bankruptythe lower the probability of bankrupty
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
FUTL (Funds (Working capital) from FUTL (Funds (Working capital) from operations/ Total Liabilities):operations/ Total Liabilities):• the greater the ability of working the greater the ability of working
capital from operations to cover total capital from operations to cover total liabilitiesliabilities
• the lower the probability of the lower the probability of bankruptcybankruptcy
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
INTWO (one if net income was INTWO (one if net income was negative for the last two years and negative for the last two years and 0 otherwise):0 otherwise):• A recent history of net losses A recent history of net losses
increases the probability of increases the probability of bankruptcybankruptcy
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
OENEG (One if total liabilities OENEG (One if total liabilities exceed total assets and zero exceed total assets and zero otherwise):otherwise):• appears redundant with TLTAappears redundant with TLTA• coefficient should be positive but is coefficient should be positive but is
negativenegative
Multivariate Bankruptcy Multivariate Bankruptcy Model:Model:Logit AnalysisLogit Analysis
CHIN (Net incomeCHIN (Net income (t) - Net Income (t-(t) - Net Income (t-1))/(INet Income (t)I + Inet Income (t-1))/(INet Income (t)I + Inet Income (t-1)I1)I
The change in net income indicates The change in net income indicates the direction and magnitude of the direction and magnitude of earnings growth or decline.earnings growth or decline.• Increasing (decreasing) earnings coupled Increasing (decreasing) earnings coupled
with the negative coefficient suggest a with the negative coefficient suggest a lower (higher) probability of bankruptylower (higher) probability of bankrupty
Synthesis of Bankruptcy Synthesis of Bankruptcy Prediction ResearchPrediction Research
Investment FactorsInvestment Factors Relative Liquidity of a Firm’s Relative Liquidity of a Firm’s
AssetsAssets Rate of Asset TurnoverRate of Asset Turnover
Relative Liquidity of a Relative Liquidity of a Firm’s AssetsFirm’s Assets
Firm’s with relatively large proportions Firm’s with relatively large proportions of current assets tend to experience of current assets tend to experience less financial distress than firms whose less financial distress than firms whose dominant assets are fixed assets or dominant assets are fixed assets or intangible assetsintangible assets
Expected return on the more liquid Expected return on the more liquid assets is usually less than the expected assets is usually less than the expected return from fixed and intangible assets return from fixed and intangible assets reflecting its lower riskreflecting its lower risk
Relative Liquidity of a Relative Liquidity of a Firm’s AssetsFirm’s Assets
Firms must balance their mix of Firms must balance their mix of assets to obtain the desired assets to obtain the desired return/risk profilereturn/risk profile
Ratios includeRatios include• Cash/Total assetsCash/Total assets• Current assets/total assetsCurrent assets/total assets• net working capital/total assetsnet working capital/total assets
Rate of Asset TurnoverRate of Asset Turnover
The more quickly assets turn over, The more quickly assets turn over, the more quickly funds work their the more quickly funds work their way toward cash on the balance way toward cash on the balance sheetsheet• Retailer has same fixed assets to total Retailer has same fixed assets to total
assets as a manufacturing firm, but assets as a manufacturing firm, but higher turnover ratios thus more higher turnover ratios thus more liquid.liquid.
Rate of Asset TurnoverRate of Asset Turnover
Ratios includeRatios include• total assets turnovertotal assets turnover• accounts receivable turnoveraccounts receivable turnover• inventory turnoverinventory turnover• the working capital turnoverthe working capital turnover• fixed asset turnoverfixed asset turnover
Financing FactorsFinancing Factors
Relative Proportion of Debt in the Relative Proportion of Debt in the Capital StructureCapital Structure• the higher the proportion of liabilities in the higher the proportion of liabilities in
the capital structurethe capital structure• the higher the probability that firms will the higher the probability that firms will
experience bankruptcyexperience bankruptcy• Firms with lower levels of debt tend to Firms with lower levels of debt tend to
have unused borrowing capacity that have unused borrowing capacity that they can depend on in times of difficultythey can depend on in times of difficulty
Financing FactorsFinancing Factors
Relative Proportion of Short-Term Relative Proportion of Short-Term Debt in the Capital StructureDebt in the Capital Structure• The more imminent due dates of debt The more imminent due dates of debt
exacerbate the risk of bankruptcyexacerbate the risk of bankruptcy Ratio includeRatio include
• Current liabilities/total assetsCurrent liabilities/total assets
Operating FactorsOperating Factors
Relative Level of ProfitabilityRelative Level of Profitability• Profitable firms ultimately turn their Profitable firms ultimately turn their
earnings into cashearnings into cash• Firms with low or negative profitability Firms with low or negative profitability
must often rely on available cash or must often rely on available cash or additional borrowing to meet financial additional borrowing to meet financial commitments as they come duecommitments as they come due
• Weak profitability and high debt ratios Weak profitability and high debt ratios usually spells financial distressusually spells financial distress
Operating FactorsOperating Factors
Profitability ratios:Profitability ratios:• net income/assetsnet income/assets• income before interest and income before interest and
taxes/assetstaxes/assets• net income/salesnet income/sales• cash flow from operations/assetscash flow from operations/assets
Operating FactorsOperating Factors
Variability of OperationsVariability of Operations Firms that experience variability in their Firms that experience variability in their
operations (cyclical sales patterns) are operations (cyclical sales patterns) are more in danger of bankruptcy than firms more in danger of bankruptcy than firms with less variabilitywith less variability
measure:measure:• change in saleschange in sales• change in net income from the previous yearchange in net income from the previous year
Other Possible Explanatory Other Possible Explanatory VariablesVariables
SizeSize• Larger firms generally have access to Larger firms generally have access to
a wider range of financing sources as a wider range of financing sources as well as more flexibility to redeploy well as more flexibility to redeploy assets than smaller firmsassets than smaller firms
• Larger firms are less subject to Larger firms are less subject to bankruptcy than smaller firmsbankruptcy than smaller firms
Other Possible Explanatory Other Possible Explanatory VariablesVariables
GrowthGrowth• Rapidly growing firms often need Rapidly growing firms often need
external financing to cover cash external financing to cover cash shortfalls from operations and permit shortfalls from operations and permit acquisitions of fixed assetsacquisitions of fixed assets
• they display high debt ratios and weak they display high debt ratios and weak profitabilityprofitability
• But their growth potential provides But their growth potential provides access to capital that permits to surviveaccess to capital that permits to survive
Other Possible Explanatory Other Possible Explanatory VariablesVariables
Qualified Audit OpinionQualified Audit Opinion• has much the same predictive has much the same predictive
accuracy as the models based on accuracy as the models based on financial ratiosfinancial ratios
Market RiskMarket Risk
Economic theory teaches that Economic theory teaches that differences in expected rates of differences in expected rates of return for different investment return for different investment alternatives should relate to alternatives should relate to differences in riskdifferences in risk
Market Rate of ReturnMarket Rate of Return
Return on common stock = Return on common stock =
Risk Free interest rate + Market Risk Free interest rate + Market beta ( market return - risk free beta ( market return - risk free interest rate)interest rate)
The beta coefficient measures the The beta coefficient measures the covariability of a firm’s returns covariability of a firm’s returns with those of all shares traded on with those of all shares traded on the marketthe market
Market RiskMarket Risk
Beta captures the systematic riskBeta captures the systematic risk The pricing of common stock The pricing of common stock
rewards shareholders they assumerewards shareholders they assume An investor can eliminate An investor can eliminate
nonsystematic risk by a diversified nonsystematic risk by a diversified portfolioportfolio
Market Beta Market Beta
Three principal explanatory Three principal explanatory variablesvariables• Degree of operating leverageDegree of operating leverage• Degree of financial leverageDegree of financial leverage• Variability of salesVariability of sales
Market BetaMarket Beta
Firms with a market beta of 1 experience Firms with a market beta of 1 experience variability equal to the averagevariability equal to the average
Firms with a market beta of more than Firms with a market beta of more than 1experience greater variability than the 1experience greater variability than the averageaverage
Firms with a beta of less than 1 Firms with a beta of less than 1 experience less variability than the experience less variability than the average firmaverage firm
Exhibit 9.6 Exhibit 9.6
UtilitiesUtilities
Have capital-intensive facilities and Have capital-intensive facilities and use extensive borrowing to finance use extensive borrowing to finance their acquisitiontheir acquisition
lowest assets turnover ratioslowest assets turnover ratios highest capital structure leverage highest capital structure leverage
ratiosratios ROCE is smallest of all the industriesROCE is smallest of all the industries Their market beta is the smallestTheir market beta is the smallest
Metals and Metal ProductsMetals and Metal Products
The metals industry takes iron ore The metals industry takes iron ore and other minerals and processes and other minerals and processes them into steel and other them into steel and other intermediate productsintermediate products
Capital intensiveCapital intensive Products tend to portray Products tend to portray
commodity characteristicscommodity characteristics
Metals and Metal ProductsMetals and Metal Products
The metal products industry takes The metal products industry takes steel and other intermediate steel and other intermediate products and processes them into products and processes them into final products that have an final products that have an element of differentiationelement of differentiation
less capital intensiveless capital intensive faster asset turnover than the faster asset turnover than the
metals industrymetals industry
Metals and Metal ProductsMetals and Metal Products
Similar capital structure leverage Similar capital structure leverage ratiosratios
ROCE is higher for the metal ROCE is higher for the metal products segment - differentiated products segment - differentiated productproduct
Market beta of metal products is Market beta of metal products is less than that for metalsless than that for metals
Grocery Stores, Food Grocery Stores, Food Processors and Processors and RestaurantsRestaurants
Less variability in the ROCE of Less variability in the ROCE of grocery stores (.74) and food grocery stores (.74) and food processors (.79) (demand is processors (.79) (demand is relatively price -inelastic) than relatively price -inelastic) than restaurants (.90) where demand restaurants (.90) where demand has greater price elasticityhas greater price elasticity
Amusements and hotelsAmusements and hotels
Heavy investments in fixed assets and debtHeavy investments in fixed assets and debt Economic conditions affect the demand for Economic conditions affect the demand for
their productstheir products Amusement industry experienced much less Amusement industry experienced much less
variability in its ROCE than hotelsvariability in its ROCE than hotels The amusements industry is also less capital The amusements industry is also less capital
intensive and debt intensive than hotelsintensive and debt intensive than hotels Amusement (.74) smaller beta than Hotel Amusement (.74) smaller beta than Hotel
(.95)(.95)
Printing and Publishing, Printing and Publishing, Lumber, and PaperLumber, and Paper
Paper industry is more capital-intensive Paper industry is more capital-intensive and debt-intensive than the printing and debt-intensive than the printing and publishing industry and the lumber and publishing industry and the lumber industryindustry
Expect market beta for printing lower Expect market beta for printing lower than lumber lower than paper industrythan lumber lower than paper industry
But 3 market betas are similar (.88, .89, But 3 market betas are similar (.88, .89, .89).89)
PetroleumPetroleum
Capital and debt intensiveCapital and debt intensive Std deviation of ROCE relatively Std deviation of ROCE relatively
highhigh Market beta the smallest of 22 Market beta the smallest of 22
industriesindustries
Bankruptcy risk and Bankruptcy risk and Market Beta RiskMarket Beta Risk
High proportions of fixed assets in High proportions of fixed assets in the asset structure provide the asset structure provide relatively illiquid assets (increasing relatively illiquid assets (increasing bankruptcy risk) and high fixed bankruptcy risk) and high fixed costs (increasing market beta risk).costs (increasing market beta risk).
Bankruptcy risk and Bankruptcy risk and Market Beta RiskMarket Beta Risk
High proportions of debt in the High proportions of debt in the capital structure require regular capital structure require regular debt servicing (increasing debt servicing (increasing bankruptcy risk) and high fixed bankruptcy risk) and high fixed costs for interest (increasing costs for interest (increasing market beta)market beta)
Bankruptcy risk and Bankruptcy risk and Market Beta RiskMarket Beta Risk
Variability of sales raises the Variability of sales raises the possibility that a firm may not possibility that a firm may not have sufficient liquid assets to have sufficient liquid assets to service debt (increasing service debt (increasing bankruptcy risk) and creates bankruptcy risk) and creates fluctuation in earnings (increasing fluctuation in earnings (increasing market beta risk)market beta risk)
Bankruptcy risk and Bankruptcy risk and Market Beta RiskMarket Beta Risk
Bankruptcy risk relates primarily to Bankruptcy risk relates primarily to an illiquidity probleman illiquidity problem
Market beta risk relates more to an Market beta risk relates more to an earnings problemearnings problem
Bankruptcy risk when it becomes Bankruptcy risk when it becomes important for a particular firm important for a particular firm intensifies the underlying market intensifies the underlying market beta riskbeta risk