In the Financial Statement Analysis Module the sub branch
above, “Risk Analysis” is organized around four sub-sections:

**Liquidity Ratios**

**Solvency Ratios**

**Coverage Ratios**

**Altman Model**

Assessing risk takes on different meanings depending upon
how risk is defined. In modern portfolio
theory risk is defined from the perspective of an investor who holds the market
portfolio. For this case risk is equated
to market risk and it is measured in terms of the stocks’ sensitivity to
general market risk, referred to as beta.
That is, beta measures the volatility contributed by the stock to the
total market portfolio volatility.

However, there are other equally valid perspectives for
assessing risk from. When viewed from a
different perspective then the appropriate measure of risk changes. For example, consider the fundamental
accounting equation, Total Assets equal Total Equities. The equity holders have claims against the
total assets and from their perspective risk is defined in terms of ability to
meet their obligations. Ratios
associated with the Analyzing Risk branch of the above tree are defined from
this perspective.

The four broad categories are defined as follows. Liquidity ratios are designed to let you
assess a company’s ability to meet its short term credit obligations. Solvency Ratios are designed to let you
assess a company’s ability to meet its long term debt obligations. Together these two sets of ratios emphasize
covering balance sheet obligations. The
third category is designed to let you assess a company’s ability to meet its
interest expense obligations. This set
of ratios is referred to as the coverage ratios and finally the Altman Model is
a traditional application of ratios designed to assess probability of
bankruptcy.

**Formula Convention for Dealing with Stocks and Flows**

In this topic we apply a common convention for working with
ratios involving a mixture of stocks and flows.
A flow variable is a variable that is measured between two points in
time. A stock variable is a variable
that is measured at a point in time. The
convention for constructing ratios is:

Convention: Stock Variables / Stock Variable, Flow
Variables/ Average Stock Variables, Average Stock Variables / Flow Variables

That is, if both the numerator and denominator of the ratio
contains only stock variables then the ratio is constructed at a point in
time. For example, the balance sheet
contains both current assets and current liabilities. The current ratio divides current assets by
current liabilities at a point in time (e.g., end of period or beginning of
period). The average current assets or
average current liabilities is not used in this ratio. If the ratio relates a flow variable, such as
earnings, to a stock variable, such as stockholders’ equity, then the usual
convention applies that divides a flow variable by the average of the stock
variable.

**Exceptions to the Above Stock/Flow Convention in Ratios:**

In some cases general practice has resulted in exceptions to
the above stock and flow conventions.
When this is the case we deviate from the convention to maintain
consistency with the widespread practice.
Some examples of this arise in this current topic with the application
of the Altman Model. Here two variables
are defined as EBIT/Total Assets, and Sales/Total Assets as opposed to using
the Average Total Assets.

**Liquidity Ratios**

Liquidity ratios can be traced back to emergence of ratio
analysis when banks started to demand financial statements in the latter 19th
century. These ratios are designed to
provide an indicator of a firm’s ability to repay its debts over the next
twelve months. As a result, they are
computed from the current assets and liabilities section of the balance
sheet. Recall, the previous topic
introduced working capital ratios. These
ratios let a user assess how efficiently a firm is transforming its inventory
into sales and how the firm is managing to collect its receivables and pay its
payables. Liquidity ratios complement
this working capital analysis by extending this to the analysis to assess
whether a firm can meet its short run or current obligations.

The primary liquidity ratios are the Current Ratio and its
major liquidity refinements the Quick and the Cash Ratios. The Quick and Cash Ratios focus upon a firm’s
ability to immediately repay its obligations.
These are defined as follows:

Current Ratio = Current
Assets/Current Liabilities

Quick Ratio = (Cash +
Marketable Securities + Accounts Receivable)/Current Liabilities

Cash Ratio = (Cash +
Marketable Securities)/Current Liabilities

A major property of the Quick Ratio is that Inventory is
excluded from Current Assets because this requires effort to convert into cash
plus it may only be quickly convertible at a significant discount. Similarly, for Accounts Receivable but the
discount is usually much smaller especially since the emergence of
securitization. Securitization is the
process of combining different company’s accounts receivable and issuing
securities against their cash flows that are sold to investors.

**Solvency versus Liquidity**

A further distinction can be made in the subsequent topic,
between liquidity and solvency.
Liquidity adopts a short run focus whereas solvency adopts a longer term
focus. Solvency ratios assess whether a
company is likely to be able to repay their debts in the longer run and thus
whether they are a going concern.

Broadly, Financial Leverage is defined as the ratio:

Total Assets/Shareholders
Equity

This can be re-expressed using the fundamental accounting
equation (using the fact that Total Assets - Total Liabilities = Shareholders’
Equity):

1/Financial Leverage = 1 + Total Liabilities/Total Assets

That is, financial leverage is a function of the Debt Ratio:

Debt Ratio = Total
Liabilities/Total Assets

There are a number of variations to the Debt Ratio and the
ones covered by the Valuation Tutor calculator are listed and defined below:

Debt to Assets = (Long
Term Debt + Debt Due within One Year) / Total Assets

Debt to Capital = (Long
Term Debt + Debt Due within One Year) / Total Equity

Debt to Equity = (Long
Term Debt + Debt Due within One Year) / Shareholders’ Equity

Financial Leverage = Total
Assets/Shareholders Equity = 1 + Total Liabilities/Shareholders Equity

Long Term Debt Ratio =
(Long Term Debt / Shareholders’ Equity)

Each of the above ratios provide a measure of the amount of
leverage used by the company and the larger the leverage the more default risk
a company has. This is because
debt-holders have a higher ranked claim to the firm’s assets over equity
holders and if their obligations are not met debt-holders can wind up the
firm. This leads to another class of
risk ratios which are referred to as coverage ratios.

**Coverage Ratios**

These ratios let you assess a company’s ability to pay
expenses and/or obligations. A common
specific coverage ratio is Interest Coverage defined as follows:

Interest Coverage =
EBIT/EBT

However, coverage ratios in general vary in terms of the
nature of the expenses and obligations, as well as employing different measurements
for ability to pay. In general, a
coverage ratio is defined as:

Coverage Ratio: Ability to
Pay divided by the Expense or Obligation being covered

Examples of expenses and obligations being covered are,
interest expense, total debt, and average current liabilities. Additional examples of ability to pay measurements
are Earnings Before Interest Taxes Depreciation and Amortizations (EBITDA),
Cash Flow from Operations (CFO) and Free Cash Flow to the Firm (FCFF). Each of these measurements provide either a
proxy for or a direct measurement of cash flows.

**Altman Model**

Risk ratios have been extensively used in practice to
predict bankruptcy or an important part of any evaluation is also to assess
whether a company is a going concern or a distressed firm. One way of approaching this problem is to develop
a scoring system that is designed to measure the probability of a firm going
bankrupt. This approach was adopted by
Altman (1968), who developed what has become known as “Altman’s Z-Score.” This is easy to calculate from traditional
financial ratios and provides a measure for the possibility of bankruptcy
within 2-years.

Altman Z-Score

Z = 1.2R1 + 1.4R2 + 3.3R3
+ 0.6*R4 + 0.999*R5

Where the accounting
ratios are defined as follows:

R1 = Net working capital
/Total assets

R2 = Retained
Earnings/Total Assets

R3 = EBIT/Total Assets

R4 = Shareholders’
Equity/Total Liabilities or Market Value of Equity/Total Liabilities

R5 = Sales/Total Assets

Interpreting Altman’s Score

Z > 2.99 is viewed as
Going Concern

2.7 < Z < 2.9 possible insolvency

1.81 < Z < 2.7
increased probability of insolvency

Z < 1.8 very high
probability

If Altman is converted to a credit rating then the following
cutoffs are usually applied:

Altman Bond

Score Rating

4 AAA

3.5 AA

2.9 A

2.5 BBB

2.25 BB

2 B

1.8 C

<1.8 D