Risk Management Systems

ACC40690

© Marcus McInerney
1
Financial Risk Management
Lecture 2
Financial Risks:
• Credit Risk
• Gearing Risk
• Project Risk
• Market Risk:
• Commodities
• Exchange Rates
• Interest Rates
Credit Risk
• Credit risk is the risk of non-payment or late payment of loan obligations for a
bank or receivables for a corporate.
• Credit risk will always exist in businesses that make credit sales and therefore it
needs to be managed.
Credit Risk  =  Default Probability  x  Exposure  x  Loss Rate
 

• Where:
• Default Probability is the probability of a debtor reneging on his debt payments.
• Exposure is the total amount the lender is supposed to get paid. In most cases, it is simply
the amount borrowed by the debtor plus interest payments.
• Loss Rate = 1 – Recovery Rate, where Recovery Rate is the proportion of the total amount
that can be recovered if the debtor defaults.
• Credit risk analysts analyze each of the determinants of credit risk and try to
minimize the aggregate risk faced by an organization.
Credit Risk: Policy Determinants
• Why have Receivables?
• Necessary Evil of Business!
• Factors influencing credit policies
• Demand for products.
• Risk of irrecoverable debts.
• Financing costs.
• Industry norms and competitors’ terms.
• Cost of credit control.
• Assessing creditworthiness
• Initial and periodic review
• Sources of information are: bank/ trade references/ published information/ credit agencies/
company’s own sales record.
• Control credit limits
• Set and maintain limits for amount of credit offered and the time taken to repay
Working Capital: Credit Risk impact on
Liquidity
•  Working capital is that capital available for conducting the day-to-day
operations of the business – it is generally current assets minus
current liabilities
• All aspects of both current assets and current liabilities need to be
managed to:
• Minimise the risk of insolvency
• Maximise the return on assets.
• The optimum level of working capital is the amount that results in no
idle resources without strain on liquid resources.
• Trade-off between profitability and liquidity
Working Capital: Importance of Liquidity
• Investing in working capital has a cost (the cost of funding or
opportunity cost of the funds being unavailable for other uses).
• To increase funding an organisation can:
• Decrease the level of current assets
• Increase the level of current liabilities
• Mismanagement of working capital can lead to business failure.
• Insolvency due to lack of liquid assets
• Overtrading
• Overstocking
• Excessive investment in working capital
Working Capital: Importance of Liquidity
• Indicators of overtrading
• Rapid increase in turnover
• Rapid increase in current assets
• Increase in inventory and receivables collection period
• Increased reliance on short term finance
• Decrease in current and quick ratio.
• Cash operating cycle (cash cycle or trading cycle)
• The operating cycle is the length of time between the company’s outlay on
raw materials, wages and other expenditures and the inflow of cash from the
sale of goods.
Working Capital: Drivers of Liquidity
• The length of the cycle = • Influences on the cash operating cycle:
Inventory days • Industry influence
+ Receivable days • Growth
– Payables days • Inflation
• Liquidity versus profitability decisions
• The amount of cash required to fund • Management efficiency
the operating cycle will:
• Increase:
• the cycle gets longer
• the level of activity / Sales increases
• Reduce:
• Improving production efficiency
• Improving finished goods and/or raw
material inventory turnover
• Improving receivables collection and
payables payment periods.
Working Capital: Indicators of Liquidity

Key Calculations Key Ratios

• Net Working Capital = CA – CL • Current Ratio = CA : CL (2:1)
• Quick Ratio = CA – INV : CL (1:1)
• Receivable Days = • W.C. Cycle =
• (Receivables/ Cr sales) * 365 days • (Rec. Days + Inv. Days) – Pay. Days
• Inventory Days =
• (Inventory/ C.O.G.S) *365 days • Working Capital T/O
• Payables Days = • Sales / NWC
• (Payables/ C.O.G.S) * 365 days
Gearing Risk
• Gearing Risk takes 2 forms
• Operating Gearing
Business Risk
• Fixed Cost Obligations
• Financial Gearing
• Fixed Financial Obligations

Operational Financial
Gearing Risk Gearing Risk
Operating Gearing

Focus On Costs Impact on Profits

• Operating gearing focus on cost structure • The more sensitive a company’s change in
• Operating gearing = profits are to a change in revenue, the
more operationally geared its profits are.
• fixed costs/total costs
• or
• fixed costs/variable costs • Operational Gearing =
• High operating gearing increases the level of • % Change in EBIT/ % change in Sales
business risk,:
Drivers: Industry firm operates in
Business Life cycle stage
Management Experience • Appendix 1 Excel Example
• https://www.cimaglobal.com/Documents/Imp
ortedDocuments/fm_sept06_p43-44.pdf
Financial Gearing
• Financial gearing
• Measures the extent to which debt is used in the capital structure.
• Prior Charge Capital/ (PCC + Equity)

• Prior Charge?
• Bank Loans > 1year
• Bond Debt
• Certain Preference share categories
• Debate: If firm continuously relies on Short term debt (overdraft) should it be included?

• Just because we can borrow, should we? Affordability ( Times Interest Cover)
• T.I.C = PBIT/ Net Interest Bill
Financial Gearing: Changing the Finance Mix
• Capital structure:
• Can the directors of a company increase shareholder wealth by changing
the capital structure?
• Impact of Financial Gearing level on the company WACC
• Could a Lower WACC result in a more valuable company??
• 1 Traditional view
• Optimal gearing level, which a firm needs to find by trial and error.
• 2 Modigliani and Miller (without tax)
• Gearing does not affect shareholder wealth
• 3 Modigliani and Miller (with tax)
• Firms should gear up as much as possible to make use of the tax relief that is
available on interest payments, but which is not available on dividends.
Gearing levels in practice
• Gearing levels tend to based on practical concerns and often follow
the industry norm.
• Problems with high levels of gearing:
• Bankruptcy risk.
• Agency costs.
• Tax exhaustion.
• Effect on borrowing capacity.
• Risk tolerance of investors may be exceeded.
• Breach of Articles of Association.
• Increases in the cost of borrowing as gearing levels rise
Graphical
representations
of 3 outcomes
Credit Scoring using Ratios

• Calculating credit scores

• The credit rating agencies use a variety of models to assess the creditworthiness
of companies.
• Eg: Kaplan Urwitz model, measures such as firm size, profitability, type of debt, gearing
ratios, interest cover and levels of risk are fed into formulae to generate a credit score.
• These scores are then used to create ratings. For example a score of above 6.76 suggests an
AAA rating.
• Popular Credit Scoring/ Financial Health Models
• Kaplan Urwitz
• Tobin Q ratio
• Altman Z Scores
Kaplan Urwitz Model
The formula for quoted companies is given as: Y = 5.67 + 0.011F + 5.13π - 2.36S –
2.85L + 0.007C – 0.87β – 2.90σ
Where
Y = The score the model produces

F = Size of the firm (Total assets) 

π = Net income / total assets 
S = Debt status ( subordinated debt = 1, else = 0)
L = Gearing (Long term debt / total assets)
C = Interest cover (PBIT / Interest payment)
β = Beta of the company from CAPM 
σ = Variance of the residuals from CAPM
equation
 ( √(σ2 – β2 – σ2m ) )
where σ2m is the variance of the market
Tobin Q Ratio
• Tobin’s Q Ratio:
• Ratio between a physical asset’s Original formula for the Q Ratio 
market value and its replacement
value.
• Combined market value of all
companies on the stock Modification of the original formula, in
market should be about equal to which the replacement costs of the assets
their replacement costs.
are replaced with their book values
Altman Z-Score
• The Z-score model is a quantitative model developed in 1968 by Edward Altman
to predict bankruptcy (financial distress) of a business, using a blend of the
traditional financial ratios and a statistical method known as multiple
discriminant analysis.

• The Z-score is known to be about 90% accurate in forecasting business failure one
year into the future and about 80% accurate in forecasting it two years into the
future.
Altman Z-Score
Formula
Z= 1.2 x (Working Capital / Total Assets)

1.4 x (Retained Earnings / Total Assets)

0.6 x (Market Value of Equity / Book Value of Debt)

0.999 x (Sales / Total Assets)

3.3 x (EBIT / Total Assets)

Z-score Probability of Failure

less than 1.8 Very High

greater than 1.81 but less than 2.99 Not Sure

greater than 3.0 Unlikely

Further Readings

Trade Credit Credit Scoring

https://finbox.com/blog/top-15-credit-ratios-investors/