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5-1
in whole or in part.
CHAPTER 5
RISK ANALYSIS
5.1 Interpreting Risk Disclosures. The SEC requires that companies identify the major
risks with Item 1A of Form 10-K. Facebook identifies almost fifty risks. These risks
cover all aspects of its business, such its users, advertising revenues, user platforms,
One intriguing risk factor discussed is the fact that the CEO has “control over
key decision making as a result of his control of a majority of our voting stock.” The
This risk factor raises issues relating to the benefits of management ownership of
firms possibly being outweighed by costs of such ownership in extreme cases.
5.2 Interpreting the Alternative Decomposition of ROCE with Negative Net Finan-
cial Obligations. Because the firm has more financial assets than financial obliga-
tions, the net financial obligations will be negative. The reformulated balance sheet
equation will still balance: Net Operating Assets = Net Financial Obligations +
Common Equity. However, Net Operating Assets will exceed Common Equity be-
cause Net Financing Obligations are negative. In computing Operating ROA,
Assets). This makes sense because the firm’s large returns from its operations are
being dampened because the firm has capital sitting in assets that generate inferior
returns relative to the firm’s operating assets.
Chapter 5
Risk Analysis
5-2
in whole or in part.
5.3 Relation between Current Ratio and Operating Cash Flow to Current Liabili-
ties Ratio. Both ratios use current liabilities in the denominator, although the cur-
lecting cash from customers but having to pay suppliers of merchandise, which
lowers cash flow from operations.
5.4 Relation between Current Ratio and Quick Ratio. The current ratio and the
quick ratio both use current liabilities in the denominator. Thus, the explanation
most likely relates to the numerator. The only differences in the numerator are that
5.5 Relation between Working Capital Turnover Ratios and Cash Flow from
Operations. The steady sales and net income should result in relatively constant
addbacks for depreciation, deferred taxes, and other non-cash expenses. The decrease
in the turnover of inventory coupled with the increase in the turnover for accounts
5.6 Effect of Transactions on Debt Ratios.
a. The effect of the four transactions on each debt ratio is as follows:
(1) Issue Long-Term Debt for Cash:
(2) Issue Short-Term Debt and Use the Cash Proceeds to Redeem Long-Term
Debt:
Chapter 5
Risk Analysis
5-3
in whole or in part.
(3) Redeem Short-Term Debt with Cash:
(4) Issue Long-Term Debt and Use the Cash Proceeds to Repurchase Common
Stock:
short- versus long-term debt, the analyst should use one of the two ratios with
total liabilities in the numerator and one of the two ratios with long-term debt in
the numerator.
cash outflow for interest. A third assumption is that the firm does not have principal
amounts to be paid in addition to interest. Furthermore, regarding the interest cov-
5.8 Interest Coverage Ratio as a Measure of Short-Term Liquidity Risk. The
interest coverage ratio uses earnings before interest, interest expense, and income
taxes of a recent period to measure the ability of a firm to cover interest expense
Chapter 5
Risk Analysis
5-4
in whole or in part.
5.9 Interpreting Operating Cash Flow to Current and Total Liabilities Ratios.
These results suggest that firms meeting the minimum threshold have, on average,
equal amounts of current and noncurrent liabilities. However, we cannot determine
what proportion of total financing comprises liabilities versus shareholders’ equity.
of importance. In a mathematical sense, a bigger number for any of the five
variables increases the size of the Z-score and reduces the probability of
bankruptcy. However, the individual variables in a multivariable model cannot be
viewed independently of the remaining variables. A particular value, such as
firm’s bankruptcy.
5.11 Market Equity Beta in Relation to Systematic and Nonsystematic Risk. The
characterization of nonsystematic risk as firm-specific risk is a misnomer because
affecting the covariability of returns and that nonsystematic risk includes variables
not affecting the covariability of returns, regardless of whether the variables are
firm-specific, industry-specific, or country-specific.
5.12 Levels versus Changes in Altman’s Bankruptcy Prediction Model. One might
argue that there is no inherent advantage of a level’s model over a change model for
either purpose. The model is simply what Altman introduced in his research study.
indirectly through the model outputs.
Chapter 5
Risk Analysis
5-5
in whole or in part.
5.13 Calculating and Interpreting Risk Ratios.
a. Revenues to Cash Ratio: $2,998/0.5($521 + $725) = 4.8
Days Accounts Receivable:
$2,998/0.5($607 + $579) = 5.1; 365/5.1 = 72 days
Days Inventory:
Long-Term Debt Ratio to Long-Term Capital Ratio:
$303/($303 + $1,640) = 0.156
Long-Term Debt to Shareholders’ Equity Ratio: $303/$1,640 = 0.185
less than the 40% found for healthy companies. The decrease in this ratio is the
result of declining cash flow from operations and increasing current liabilities.
Net income increased each year so that the declining cash flow from operations
is the result of changes in non-cash revenues and expenses and in operating
other current liabilities in Year 4. The analyst would be concerned with the de-
crease in current liabilities in Year 4 only if it signaled pressure from suppliers
of various goods and services to pay their amounts due. Even then, Hasbro has
more than sufficient cash and accounts receivable to cover all current liabilities.
Chapter 5
Risk Analysis
5-6
in whole or in part.
year when sales increased. The net days of working capital increased again in
Year 4, a year in which sales decreased. It would not appear that Hasbro is
unduly risky in terms of short-term liquidity risk at the end of Year 4. Its current
and quick ratios are at healthy levels and its days inventory and accounts paya-
become troublesome.
c. Hasbro’s long-term solvency risk has decreased significantly during the three-
year period. Debt levels have declined as Hasbro has redeemed debt. (See
Hasbro’s statement of cash flow in Exhibit 4.30.) Its interest coverage ratio has
5.14 Calculating and Interpreting Risk Ratios.
a. Revenues to Cash Ratio: $2,021/0.5($56 + $350) = 10.0
Days Revenues in Cash: 365/10 = 37 days
Current Ratio: $652/$414 = 1.6
365/15.4 = 24 days
Net Days Working Capital: 3 + 78 – 24 = 57 days
Operating Cash Flow to Current Liabilities Ratio:
Chapter 5
Risk Analysis
5-7
in whole or in part.
recompute these ratios to include marketable securities, the revenues to cash
ratio is 4.8 in fiscal Year 3 (76 days), 3.6 in fiscal Year 4 (101 days), and 4.6 in
fiscal Year 5 (79 days). These appear to be very healthy ratios from the
viewpoint of short-term liquidity risk. The current and quick ratios are at healthy
increase in the number of days inventory is held. The products of Abercrombie
& Fitch are trendy. A buildup of inventory is undesirable. However, the increase
in days inventory may be simply due to stocking the rapid growth in new stores.
cash flow to total liabilities ratio is well above the 20% threshold for a healthy
company; its interest coverage ratio is healthy as well. Thus, despite the heavy
debt load, Abercrombie & Fitch appears able to service this debt at this time.
5.15 Interpreting Risk Ratios.
to current liabilities ratio has been decreasing, but it remains above the desired
level of 40%. This is not too worrisome given that the firm has a demonstrated
ability to sell products for considerably more than their book value.
long-term solvency risk is still low.
Chapter 5
Risk Analysis
5-8
in whole or in part.
c. Amounts shown for PepsiCo throughout the chapter are consolidated into the
following table:
PepsiCo Coca-Cola
2008 2008 2007 2006
Revenues to Cash Ratio .......... 29.1 6.9 8.4 6.5
Days Revenues in Cash ........... 17.5 53 44 56
Current Ratio ........................... 1.2 0.9 0.9 0.9
Liabilities to Shareholders’
Equity Ratio ......................... 1.973 0.979 0.990 0.771
Long-Term Debt to Long-
Term Capital Ratio ............... 0.394 0.120 0.131 0.072
Long-Term Debt to Share-
the lower cash holdings. The current and quick ratios of the two firms are
similar. The operating cash flow to current liabilities ratio for both firms is well
above the desired level of 0.40, with PepsiCo having a higher ratio. The two
firms have similar days accounts receivable outstanding. Coca-Cola’s days
d. Neither PepsiCo nor Coca-Cola displays much long-term solvency risk.
However, PepsiCo appears to have somewhat higher long-term solvency risk
Chapter 5
Risk Analysis
5-9
in whole or in part.
0.20 desired level and very high interest coverage ratios, although the ratios for
Coca-Cola exceed those for PepsiCo.
Firm That Declared Bankruptcy.
a. (1) Current Ratio:
(2) Operating Cash Flow to Current Liabilities Ratio:
(3) Liabilities to Assets Ratio:
(4) Long-Term Debt to Long-Term Capital Ratio:
(5) Operating Cash Flow to Total Liabilities Ratio:
(6) Interest Coverage Ratio:
not covered.
Chapter 5
Risk Analysis
5-10
in whole or in part.
b. Altman’s Z-Score
2000
Working Capital/Assets: 1.2[($3,205 – $5,245)/$21,931] ..................... (0.112)
Retained Earnings/Assets: 1.4($4,176/$21,931).................................... 0.267
2001
Working Capital/Assets: 1.2[($3,567 – $6,403)/$23,605] ..................... (0.144)
Retained Earnings/Assets: 1.4($2,930/$23,605).................................... 0.174
2002
Working Capital/Assets: 1.2[($3,902 – $6,455)/$24,720] ..................... (0.124)
Retained Earnings/Assets: 1.4($1,639/$24,720).................................... 0.093
2003
Working Capital/Assets: 1.2[($4,550 – $6,157)/$25,939] ..................... (0.074)
Retained Earnings/Assets: 1.4($844/$25,939) ...................................... 0.046
