### Risk Analysis

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