Risk Analysis: An Extended Look

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 • Indicatesa 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 , Pro Forma financial statements represent forecasted income statements, balance sheets, and statements of cash flows for some number of years into the future • 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

Risk Analysis: An Extended Look