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How much risk do equity investors in a firm faceMeasuring Risk How risky are the investments the firm has made over time? How much risk do equity investors in a firm face? These are two more questions that we would like to find the answer to in the course of an investment analysis. Accounting statements do not really claim to measure or quantify risk in a systematic way, other than to provide footnotes and disclosures where there might be risk embedded in the firm. In this section, we will examine some of the ways in which accountants try to assess risk. Accounting Principles Underlying Risk Measurement To the extent that accounting statements and ratios do attempt to measure risk, there seem to be two common themes. , i.e. the risk that a fixed obligation, such as interest or principal due on outstanding debt, will not be met. The broader equity notion of risk, which measures the variance of actual returns around expected returns, does not seem to receive much attention. Thus, an all-equity-financed firm with positive earnings and few or no fixed obligations will generally emerge as a low-risk firm from an accounting standpoint, in spite of the fact that its earnings are unpredictable. of a firm at a point in time to meet its obligations. For instance, when ratios are used to assess a firms risk, the ratios are almost always based upon one periods income statement and balance sheet. Accounting Measures of Risk Accounting measures of risk can be broadly categorized into two groups. The first is disclosures about potential obligations or losses in values that show up as footnotes on balance sheets, which are designed to alert potential or current investors to the possibility of significant losses. The second is the ratios that are designed to measure both liquidity and default risk. Disclosures in Financial Statements In recent years, the number of disclosures that firms have to make about future obligations has proliferated. Consider, for instance, the case of contingent liabilities . These refer to potential liabilities that will be incurred under certain contingencies, as is the case when a firm is the defendant in a lawsuit. The general rule that has been followed is to ignore contingent liabilities which hedge against risk, since the obligations on the contingent claim will be offset9 by benefits elsewhere. In recent periods, however, significant losses borne by firms from supposedly hedged derivatives positions (such as options and futures) have led to FASB requirements that these derivatives be disclosed as part of a financial statement. In fact, pension fund and health care obligations have moved from mere footnotes to actual liabilities for firms. Financial Ratios Financial statements have long been used as the basis for estimating financial ratios that measure profitability, risk and leverage. In the section on earnings, we looked at two of the profitability ratios - return on equity and return on capital . In this section, we will look at some of the financial ratios that are often used to measure the financial risk in a firm. 1. Short-Term Liquidity Risk Short-term liquidity risk arises primarily from the need to finance current operations. To the extent that the firm has to make payments to its suppliers before it gets paid for the goods and services it provides, there is a cash shortfall that has to be met, usually through short-term borrowing. Though this financing of working capital needs is done routinely in most firms, financial ratios have been devised to keep track of the extent of the firms exposure to the risk that it will not be able to meet its short-term obligations. The two most frequently used to measure short-term liquidity risk are the current ratio and the quick ratio. The current ratio is the ratio of current assets (cash, inventory, accounts receivable) to its current liabilities (obligations coming due within the next period). A current ratio below one, for instance, would indicate that the firm has more obligations coming due in the next year than assets it can expect to turn to cash. That would be an indication of liquidity risk. While traditional analysis suggests that firms maintain a current ratio of 2 or greater, there is a trade-off here between minimizing liquidity risk and tying up more and more cash in net working capital (Net working capital = Current Assets - Current Liabilities). In fact, it can be reasonably argued that a very high current ratio is indicative of an unhealthy firm, which is having problems reducing its inventory. In recent years, firms have worked at reducing their current ratios and managing their net working capital better. Reliance on current ratios has to be tempered by a few concerns. First, the ratio can be easily manipulated by firms around the time of financial reporting dates to give the illusion of safety; second, current assets and current liabilities can change by an equal amount, but the effect on the current ratio will depend upon its level10 before the change. The quick or acid test ratiois a variant of the current ratio. It distinguishes current assets that can be converted quickly into cash (cash, marketable securities) from those that cannot (inventory, accounts receivable). The exclusion of accounts receivable and inventory is not a hard and fast rule. If there is evidence that either can be converted into cash quickly, it can, in fact, be included as part of the quick ratio. Turnover ratiosmeasure the efficiency of working capital management by looking at the relationship of accounts receivable and inventory to sales and to the cost of goods sold. Sales These ratios can be interpreted as measuring the speed with which the firm turns accounts receivable into cash or inventory into sales. These ratios are often expressed in terms of the number of days outstanding. 2. Long-term Solvency and Default risk Measures of long-term solvency attempt to examine a firms capacity to meet interest and principal payments in the long term. Clearly, the profitability ratios discussed earlier in the section are a critical component of this analysis. The ratios specifically designed to measure long term solvency try to relate profitability to the level of debt payments, to identify the degree of comfort with which the firm can meet these payments. Interest Coverage Ratios The interest coverager atio measures the capacity of the firm to meet interest payments from pre-debt, pre-tax earnings. The higher the interest coverage ratio, the more secure is the firms capacity to make interest payments from earnings. This argument however has to be tempered by the recognition that earnings before interest and taxes is volatile and can drop significantly if the economy enters a recession. Consequently, two firms can have the same interest coverage ratio but be viewed very differently in terms of risk. The denominator in the interest coverage ratio can be easily extended to cover other fixed obligations such as lease payments. If this is done, the ratio is called a fixed charges coverage ratio. Finally, this ratio, while stated in terms of earnings, can be restated in terms of cash flows, by using earnings before interest, taxes and depreciation (EBITDA) in the numerator and cash fixed charges in the denominator. Both interest coverage and fixed charge ratios are open to the criticism that they do not consider capital expenditures, a cash flow that may be discretionary in the very short term, but not in the long term if the firm wants to maintain growth. One way of capturing the extent of this cash flow, relative to operating cash flows, is to compute a ratio of the two. While there are a number of different definitions of cash flows from operations, the most reasonable way of defining it is to measure the cash flows from continuing operations, before interest but after taxes, and after meeting working capital needs. Cash flow from operations = EBIT (1-tax rate) - ?Working Capital There is a dataset on the web that summarizes the interest coverage and fixed charge coverage ratios for firms in the United States, classified by industry. Boeing, based upon its operating income in 1998, looks riskier than the Home Depot on both the interest coverage ratio and fixed charge coverage ratio basis. On a cash flow basis, however, Boeing does look much better. In fact, when capital expenditures are considered, the Home Depot has a lower ratio. For Boeing, the other consideration is the fact that operating income in 1998 was depressed, relative to income in earlier years, and this does have an impact on the ratios across the board. It might make more sense when computing these ratios to look at the average figures over time. finratio.xls: This spreadsheet allows you to compute the interest coverage and fixed charge coverage ratios for a firm, based upon financial statement data. Debt Ratios Interest coverage ratios measure the capacity of the firm to meet interest payments but do not examine whether it can pay back the principal on outstanding debt. Debt ratios attempt to do this, by relating debt to total capital or to equity. The two most widely used debt ratios are: The first ratio measures debt as a proportion of the total capital of the firm and cannot exceed 100%. The second measures debt as a proportion of equity in the firm and can be easily derived from the first. While these ratios presume that capital is raised from only debt and equity, they can be easily adapted to include other sources of financing, such as preferred stock. While preferred stock is sometimes combined with common stock under the equity label, it is better to keep it separate and to compute the ratio of preferred stock to capital (which will include debt, equity and preferred stock). a. Variants on Debt Ratios There are two close variants of debt ratios. In the first, only long-term debt is used rather than total debt, with the rationale that short-term debt is transitory and will not affect the long-term solvency of the firm. Equity Given the ease with which firms can roll over short-term debt, and the willingness of many firms to use short-term financing to fund long-term projects, these variants can provide a misleading picture of the firms financial leverage risk. The second variant of debt ratios uses market value (MV) instead of book value, primarily to reflect the fact that some firms have a significantly greater capacity to borrow than their book values indicate. Many analysts disavow the use of market value in their calculations, contending that market values, in addition to being difficult to get for debt, are volatile and hence unreliable. These contentions are open to debate. It is true that the market value of debt is difficult to get for firms which do not have publicly traded bonds, but the market value of equity is not only easy to obtain, it is constantly updated to reflect market-wide and firm-specific changes. Furthermore, using the book value of debt as a proxy for market value in those cases where bonds are not traded does not significantly shift11 most market-value based debt ratios. 11 Deviations in the market value of equity from book value are likely to be much larger than deviation for debt and are likely to dominate in most debt ratio calculations. Boeing has a much higher book value debt ratio, both long term and total debt, than the Home Depot. dbtfund.xl: There is a dataset on the web that summarizes the book value debt ratios and market value debt ratios for firms in the United States, classified by industry. Other issues in analyzing financial statements Two more issues bear consideration before we conclude this section on financial statements. The first relates to differences in accounting standards and practices and how these differences may color comparisons across companies and the second relates to accounting for acquisitions and how this can affect both the acquisition method and price. |
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