Risk Analysis: An Extended Look Dr. Nancy Mangold California State University, East Bay

Credit Risk  A firm’s ability to make interest and principal payments on borrowings

Bankruptcy Risk  The likelihood that a firm will file for bankruptcy and perhaps subsequently liquidate

Financial distress continuum  Failing to make a required interest payment on time  defaulting on a principal payment on debt  filing for bankruptcy  liquidating a firm

Financial Distress  Analysts concerned with the economic loss of a portion or all of the amount lent to or invested in a firm can examine a firm’s position on this financial distress continuum.

Broader definition of risk  To explain the differences in market rates of return of common stocks  Economic theory holds that the differences in market return must relate to differences in perceived risk

Risk measure : Market equity beta  Market equity beta used as the measure of risk  Market equity beta measures the covariability of a firm’s returns with the returns of all securities in the market

Sources of Debt Financing: Commercial Banks  Commercial banks lend funds to firms to finance • • • working capital needs accounts receivable inventory  Accounts receivable and inventory serve as collateral  Usually short-term: less than one year  Appear in Current liabilities - notes payable

Sources of Debt Financing: Commercial Banks  Commercial banks also provide funds to purchase equipment, buildings, and other long-term assets  These loans extend for periods of 20 or more years  Specific assets financed used as a collateral  appear in the long-term debt payable category

Sources of Debt Financing: Other Financial Institutions  Firms may also obtain funds from • Insurance companies • • finance companies other financial institutions  Finance long-term assets  Assets serve as collateral for the borrowing

Sources of Debt Financing: Commercial paper Market  Firms issue commercial paper for very short-term needs for cash • meet payroll before collecting cash from accounts receivable monthly  Unsecured  Included in notes payable- current liabilities

Sources of Debt Financing: Commercial paper Market  Large established firms with solid credit status most easily access the commercial paper market for funds  Lenders in the commercial paper • financial institutions • • business enterprises with excess cash money market mutual funds

Sources of Debt Financing: Unsecured Debt Market  Firms needing long-term sources of funds can issue bonds on the open market  Bonds are unsecured  Priced according to • the overall credit quality of the issuer • the term to maturity of the bonds • the general level of interest rates in the market

Sources of Debt Financing: Unsecured Debt Market  In Bankruptcy • First: secured (collateralized lenders • • • second: bonds holders third: preferred stockholdrs last: common stockholders  Long term debt payable on balance sheet  investors: financial institutions, mutual funds, pension funds and individuals

Sources of Debt Financing: Suppliers  Suppliers of various goods and services that do not require firms to pay immediately implicitly provide funds to the firm  Suppliers of raw materials or merchandise inventories may require that the inventories serve as collateral for the delayed payment

Credit Risk Analysis  Circumstances leading to need for the loan  Cash Flows  Collateral  Capacity for Debt  Contingencies  Character of Management  Conditions

Circumstances leading to need for the loan  The reason that a firm needs to borrow affects the riskiness of the loan and the likelihood of repayment

W.T. Grant Company  Discount retail chain filed for bankruptcy in 1975  Between 1968 and 1975 Grant experienced increasing difficulty collecting accounts receivables.

 Borrow short-term funds from commercial banks to finance the buildup of its accounts receivable

W.T. Grant Company  Lending to satisfy cash flow needs related to an unsolved problem or difficulty can be highly risky

Toys “R” Us  Purchases toys, games, and other entertainment products in September and October in anticipation of heavy demand during the end-of-the year holiday season  Typically pays its suppliers within 30 days for these purchases, but doesn’t collect cash from customers until December, January or later

Toys “R” Us  Borrow short term funds from its banks to finance its inventory  Repays these loans with cash collected from customers  Lending to satisfy cash flow needs related to ongoing seasonal business operations is generally relatively low risk  Toys “R” Us has an established brand name and predictable demand and diverse product line

Wal-Mart Stores  Grows the number of its stores at a rate of 12% per year during the last five years  The fastest growth is in its superstores ( a combination of its traditional discount store and a grocery store).

 Borrows a large portion of the funds needed to construct new stores using 20 to 25-year loans

Wal-Mart Stores  Also enters into leases for a significant portion of the space needed for its new stores  Such loans are relatively low risk • given Wal-Mart’s operating success in the past • the land and buildings that serve as collateral for the loans

Data General Corporation  mMaintained a presence in the midsize computer market for several decades  Technological advances and aggressive marketing by competitors have eroded its share of the computer market .

Data General Corporation  Wanted to develop new technologies for internet products  Needed to borrow funds to finance its research and development effort

Data General Corporation  Such a loan would be relatively high-risk • embarking on a new line of business for which it does not necessarily have a competitive advantage • rapid technology change • R&D expenditures may not result in assets that can be serve as collateral for the loan

Lower credit risk  Lending to established firms for ongoing operating needs

Higher credit risks  Lending to firms experiencing operating problems  Lending to emerging businesses  Lending to support investments in intangible assets typically carry higher risks

Cash Flows  Lenders want firms to generate sufficient cash flow to pay interest and repay principal on a loan so they don’t have to rely on selling the collateral

Cash Flows  Tools for studying the cash-generating ability of a firm • • • examination of the statement of cash flows for recent years computation of various cash flow-based financial ratios study of projected financial statements

Statement of Cash Flows  Indicators of potential cash flow problems if observed for several years in a row  Growth in accounts receivable or inventories that exceeds the growth rate in sales  Increases in accounts payable that exceed the increase in inventories

Indicators of potential cash flow problems  Other current liabilities that grow at a faster rate than sales  Persistent negative cash flow from operations because of net losses or substantial increases in net working capital

Indicators of potential cash flow problems  Capital expenditures that substantially exceed cash flow from operations • indicates a firm’s continuing need for external financing to sustain growth  Reductions in capital expenditures over time • signal declines in future sales, earnings, and operating cash flows

Indicators of potential cash flow problems  Sales of marketable securities in excess of purchases of marketable securities • signal the inability of a firm’s operations to provide adequate cash flow to finance working capital and long-term investments

Indicators of potential cash flow problems  A substantial shift from long-term borrowing to short-term borrowing • signal a firm’s inability to obtain long-term loans because lenders are uncertain about a firm’s future  A reduction or elimination of dividend payments • a negative signal about a firm’s future prospects

Cash Flow Financial Ratios  Cash Flow from operations Average Current liabilities  Indicates the ability of a firm to generate sufficient cash flows from operations to repay liabilities coming due with the next year

Cash Flow Financial Ratios  Cash flow from operations Average Total Liabilities  Indicates a firm’s ability to generate sufficient cash flow to repay all liabilities

Cash Flow Financial Ratios  Cash flow from operations Capital Expenditures  Indicates the ability of a firm to finance capital expenditures with operating cash flows  <1 indicates a will need to continue to find various sources of capital to finance capital expenditures to continue its growth

Projected Financial Statements  Projected financial statements , of years into the future Pro Forma financial statements represent forecasted income statements, balance sheets, and statements of cash flows for some number  Lenders require potential borrowers to prepare such statements to demonstrate the borrower’s ability to repay the loan with interest as it comes due

Projected Financial Statements  The credit analyst should question each of the important assumptions underlying these projected financial statements • • • sales growth cost structure capital expenditure plans  Should also assess the sensitivity of the projected cash flows to change sin key assumptions

Collateral  The availability and value of collateral for a loan  If cash flows are insufficient to pay interest and repay the principal on a loan, the lender has the right to obtain any collateral pledged in support of the loan

Collateral  Marketable Securities reported at at market value on balance sheet (< 20% ownership)  Assess whether the market value of securities pledged as collateral exceeds the unpaid balance of a loan

Collateral  Accounts Receivable  Assess whether the current value of accounts receivable is sufficient to cover the unpaid portion of a loan collateralized by accounts receivable

Collateral  Examine • changes in provision for uncollectible accounts relative to sales • the balance in allowance for uncollectible accounts relative to gross accounts receivable • • the amount of accounts written off as uncollectible relative to gross accounts receivable the number of days receivables are outstanding

Inventories  Examine • Changes in inventory turnover rate • • Cost of goods sold to sales percentage Mix of raw materials, work in process inventories, and finished goods inventories to identify possible inventory obsolescence problems

Inventories  LIFO inventories market value exceed the book value  FIFO inventories will be closer to market value  Using footnotes on the excess of market or FIFO value over LIFO cost permit the analyst to assess the adequacy of LIFO inventories to cover the unpaid balance on a loan collateralized by inventories

Property, Plant and Equipment  Fixed assets as collateral for long-term borrowing  Determining the market values of such assets is difficult using reported financial statement information because the use of historical cost valuations  Market values of unique, firm-specific assets are particularly difficult to ascertain.

Property, Plant and Equipment  Clues indicating market value declines include • • • restructuring charges asset impairment charges related to such assets recent sales at a loss

Nonsecured lending  Study the notes to the financial statements to ascertain how much of the borrower’s assets are not already pledged or restricted  The liquidation value of such assets represents the available resources of a firm to repay unsecured creditors

Nonsecured lending  For small business, additional source of collateral may be • personal assets of management or major shareholders

Capacity for Debt  A firm’s capacity to assume additional debt  A firm’s cash flows and collateral represent the means to repay the debt  Most firms do not borrow up to the limit of their debt capacity  Lenders want to make sure that a margin of safety exists

Capacity for Debt: Debt Ratios  long-term debt ( total liabilities ) / total assets  long-term debt ( total liabilities ) /shareholders’ equity  consider off-balance sheet obligations • operating lease commitments • • underfunded pension health care benefit obligation

Capacity for Debt: Debt Ratios  The higher the debt ratios  The higher the credit risk  The lower the unused debt capacity of the firm

Capacity for Debt: Interest Coverage Ratio  Operating income before interest and taxes / interest payments  A measure of margin of safety provided by operations to service debt

Capacity for Debt: Interest Coverage Ratio  When firms make heavy use of operating leases for their fixed assets, the analyst might convert the operating leases to capital leases for the purpose of computing the interest coverage ratio  add back the lease payments to net income  include the lease payments in the denominator

Capacity for Debt: Interest Coverage Ratio  <2 high credit risk  > 4 capacity to carry additional debt

Contingencies  Is the firm a defendant in a major lawsuit involving its principal products  Negative legal judgments will likely have a more pronounced effect on smaller firms • • • less resource to defend themselves less resource to sustain such losses may not carry adequate insurance

Contingencies  Has the firm served as guarantor on a loan by a subsidiary, joint venture, or corporate officer

Contingencies  Has the firm committed itself to make payments related to derivative financial instruments that could adversely affect future cash flows if interest rate, exchange rates or other prices change significantly in an unexpected direction?

Contingencies  Is the firm dependent on one or a few • key employees, • • • contracts license agreements, or technologies  whose loss could substantially affect the viability of the business?

Contingencies  Examine notes to the financial statements  Ask questions of management, attorneys and others.

Character of Management  Has the management team successfully weathered previous operating problems and challenges that could have bankrupted most firms?

Character of Management  Has the management team delivered in the past on projections made with regard to • • • • sales level cost reductions new product development other operating targets

Character of Management  Does the firm have a reputation for honest and fair dealings with suppliers, customers, bankers, and others?

 Do managers have a substantial portion of their personal wealth invested in the firm’s common equity • managers have incentives to operate the firm profitably and avoid defaulting on debt to increse the value of their equity holding

Conditions  Lenders often place restrictions or constraints on a firm to protect their interests • • • • Minimum level of certain financial ratios (current ratio > 1.2)) maximum level of certain financial ratios (debt/equity ratio < 75%) Restrictions on paying dividends Limit on new financing

Conditions  Debt covenants can protect the interest of senior, collateralized lenders • protection again undue deterioration in the financial condition of a firm  They can place less senior lenders in jeopardy if the firm must quickly liquidate assets to repay debt • increase the likelihood of default or bankruptcy if the constraints are too tight

The Bankruptcy Process  firms may file under Chapter XI of the National Bankruptcy Code  Firms have four months to present a plan of reorganization to the court  After four months, creditors, employees and others can file their plans of reorganization

The Bankruptcy Process  The court decides which plan provides the fairest treatment for all parties concerned  When the court determines that the firm has executed the plan of reorganization successfully and appears to be viable entity, the firm is released from bankruptcy

The Bankruptcy Process  A Chapter XII filing for bankruptcy entails an immediate sale or liquidation of the firm’s assets and a distribution of the proceeds to the various claimants in the order of their priority.

Models of Bankruptcy Prediction  Univariate Bankruptc;y Prediction Models examine the relation between a particular financial statement ratio and bankruptcy

Univariate Bankruptcy Prediction Models  Beaver studied 29 financial statement ratios for the five years preceding bankruptcy for a sample of bankrupt and non-bankrupt firms

Univariate Bankruptcy Prediction Models  The six ratios with the best discriminating power are  (long-term solvency risk • NI before depreciation, depletion and amortization/ Total Liabilities  Profitability • NI/Total Assets

Univariate Bankruptcy Prediction Models  Long-term solvency risk • Total Debt/ Total Assets  Short-term liquidity risk • Net working capital/Total Assets  Short-term liquidity risk • Current Assets/ Current Liabilities  Short-term liquidity risk • Cash, marketable securities, accounts receivable/operating expenses

Multivariate Bankruptcy Prediction Models  Multiple Discriminant Analysis (MDA)  The best-known MDA bankruptcy prediction model is Altman’s Z-score

Altmans Bankruptcy Prediction Model Z = 1.2(NWC/TA)+ 1.4(RE/TA)+ 3.3(EBIT/TA) + .6(MV-EQ/BV-Liab)+ 1.0(S/TA)  MWC/TA1:(current assets - current liabilities)/total assets  measure the proportion of total assets representing relatively liquid net current assets (ST liquidity risk)

Altman’s Bankruptcy Prediction Model  RE/TA: retained earnings / total assets  measures accumulated profitability and relative age of a firm   EBIT/TA: EBIT / total assets  measures current profitability

Altman’s Bankruptcy Prediction Model  MV-EQ/BV-Liab: market value of preferred and common equity / book value of total liabilities  market’s overall assessment of the profitability and risk of the firm  S/TA: sales / total assets  measures ability of a firm to use assets to generate sales

Altman’s Bankruptcy Prediction Model  If Z > 2.99 assign to nonbankrupt group, low probability of bankruptcy  If Z < 1.81 assign to bankrupt group, higher probability of bankruptcy  1.81 < Z < 2.99 gray area

Multivariate Bankruptcy Prediction Models  James Ohlson used Logit Analysis to discriminate bankrupt from non-bankrupt firms  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)

Multivariate Bankruptcy Model: Logit Analysis  Size: larger firms have greater flexibility to curtail capacity, sell assets, and attract debt or equity capital than smaller firms  TLTA (Total Liabilities/ Total Assets) : • Long-term solvency risk • Higher debt ratios increase the probability of bankruptcy

Multivariate Bankruptcy Model: Logit Analysis  WCTA (Working capital/Total Assets: • the higher the proportion of net working capital to total assets, • the more liquid are the assets • the lower the probability of bankruptcy

Multivariate Bankruptcy Model: Logit Analysis  CLCA (Current Liabilities/Current Assets): • An excess of current liabilities over current assets is also an indicator of short-term liquidity risk

Multivariate Bankruptcy Model: Logit Analysis  NITA (Net Income/Total Assets): • the higher the rate of profitability, • • the less likely a firm will experience difficulty servicing debt the lower the probability of bankrupty

Multivariate Bankruptcy Model: Logit Analysis  FUTL (Funds (Working capital) from operations/ Total Liabilities): • • the greater the ability of working capital from operations to cover total liabilities the lower the probability of bankruptcy

Multivariate Bankruptcy Model: Logit Analysis  INTWO (one if net income was negative for the last two years and 0 otherwise): • A recent history of net losses increases the probability of bankruptcy

Multivariate Bankruptcy Model: Logit Analysis  OENEG (One if total liabilities exceed total assets and zero otherwise): • • appears redundant with TLTA coefficient should be positive but is negative

Multivariate Bankruptcy Model: Logit Analysis  CHIN (Net income (t) - Net Income (t 1))/(INet Income (t)I + Inet Income (t-1)I  The change in net income indicates the direction and magnitude of earnings growth or decline.

• Increasing (decreasing) earnings coupled with the negative coefficient suggest a lower (higher) probability of bankrupty

Synthesis of Bankruptcy Prediction Research  Investment Factors  Relative Liquidity of a Firm’s Assets  Rate of Asset Turnover

Relative Liquidity of a Firm’s Assets  Firm’s with relatively large proportions of current assets tend to experience less financial distress than firms whose dominant assets are fixed assets or intangible assets  Expected return on the more liquid assets is usually less than the expected return from fixed and intangible assets reflecting its lower risk

Relative Liquidity of a Firm’s Assets  Firms must balance their mix of assets to obtain the desired return/risk profile  Ratios include • Cash/Total assets • Current assets/total assets • net working capital/total assets

Rate of Asset Turnover  The more quickly assets turn over, the more quickly funds work their way toward cash on the balance sheet • Retailer has same fixed assets to total assets as a manufacturing firm, but higher turnover ratios thus more liquid.

Rate of Asset Turnover  Ratios include • total assets turnover • • • • accounts receivable turnover inventory turnover the working capital turnover fixed asset turnover

Financing Factors  Relative Proportion of Debt in the Capital Structure • • • the higher the proportion of liabilities in the capital structure the higher the probability that firms will experience bankruptcy Firms with lower levels of debt tend to have unused borrowing capacity that they can depend on in times of difficulty

Financing Factors  Relative Proportion of Short-Term Debt in the Capital Structure • The more imminent due dates of debt exacerbate the risk of bankruptcy  Ratio include • Current liabilities/total assets

Operating Factors  Relative Level of Profitability • Profitable firms ultimately turn their earnings into cash • Firms with low or negative profitability must often rely on available cash or additional borrowing to meet financial commitments as they come due • Weak profitability and high debt ratios usually spells financial distress

Operating Factors  Profitability ratios: • net income/assets • • • income before interest and taxes/assets net income/sales cash flow from operations/assets

Operating Factors  Variability of Operations  Firms that experience variability in their operations (cyclical sales patterns) are more in danger of bankruptcy than firms with less variability  measure: • change in sales • change in net income from the previous year

Other Possible Explanatory Variables  Size • Larger firms generally have access to a wider range of financing sources as well as more flexibility to redeploy assets than smaller firms • Larger firms are less subject to bankruptcy than smaller firms

Other Possible Explanatory Variables  Growth • Rapidly growing firms often need external financing to cover cash shortfalls from operations and permit acquisitions of fixed assets • • they display high debt ratios and weak profitability But their growth potential provides access to capital that permits to survive

Other Possible Explanatory Variables  Qualified Audit Opinion • has much the same predictive accuracy as the models based on financial ratios

Market Risk  Economic theory teaches that differences in expected rates of return for different investment alternatives should relate to differences in risk

Market Rate of Return  Return on common stock = Risk Free interest rate + Market beta ( market return - risk free interest rate)  The beta coefficient measures the covariability of a firm’s returns with those of all shares traded on the market

Market Risk  Beta captures the systematic risk  The pricing of common stock rewards shareholders they assume  An investor can eliminate nonsystematic risk by a diversified portfolio

Market Beta  Three principal explanatory variables • Degree of operating leverage • • Degree of financial leverage Variability of sales

Market Beta  Firms with a market beta of 1 experience variability equal to the average  Firms with a market beta of more than 1experience greater variability than the average  Firms with a beta of less than 1 experience less variability than the average firm  Exhibit 9.6

Utilities  Have capital-intensive facilities and use extensive borrowing to finance their acquisition  lowest assets turnover ratios  highest capital structure leverage ratios  ROCE is smallest of all the industries  Their market beta is the smallest

Metals and Metal Products  The metals industry takes iron ore and other minerals and processes them into steel and other intermediate products  Capital intensive  Products tend to portray commodity characteristics

Metals and Metal Products  The metal products industry takes steel and other intermediate products and processes them into final products that have an element of differentiation  less capital intensive  faster asset turnover than the metals industry

Metals and Metal Products  Similar capital structure leverage ratios  ROCE is higher for the metal products segment - differentiated product  Market beta of metal products is less than that for metals

Grocery Stores, Food Processors and Restaurants  Less variability in the ROCE of grocery stores (.74) and food processors (.79) (demand is relatively price -inelastic) than restaurants (.90) where demand has greater price elasticity

Amusements and hotels  Heavy investments in fixed assets and debt  Economic conditions affect the demand for their products  Amusement industry experienced much less variability in its ROCE than hotels  The amusements industry is also less capital intensive and debt intensive than hotels  Amusement (.74) smaller beta than Hotel (.95)

Printing and Publishing, Lumber, and Paper  Paper industry is more capital-intensive and debt-intensive than the printing and publishing industry and the lumber industry  Expect market beta for printing lower than lumber lower than paper industry  But 3 market betas are similar (.88, .89, .89)

Petroleum  Capital and debt intensive  Std deviation of ROCE relatively high  Market beta the smallest of 22 industries

Bankruptcy risk and Market Beta Risk  High proportions of fixed assets in the asset structure provide relatively illiquid assets (increasing bankruptcy risk) and high fixed costs (increasing market beta risk).

Bankruptcy risk and Market Beta Risk  High proportions of debt in the capital structure require regular debt servicing (increasing bankruptcy risk) and high fixed costs for interest (increasing market beta)

Bankruptcy risk and Market Beta Risk  Variability of sales raises the possibility that a firm may not have sufficient liquid assets to service debt (increasing bankruptcy risk) and creates fluctuation in earnings (increasing market beta risk)

Bankruptcy risk and Market Beta Risk  Bankruptcy risk relates primarily to an illiquidity problem  Market beta risk relates more to an earnings problem  Bankruptcy risk when it becomes important for a particular firm intensifies the underlying market beta risk