Chapter 4

CHAPTER IV
THE RISK ANALYSIS

OVERVIEW OF RISK ANALYSIS
- Risk is the potential of gaining or losing something of

value.
- Risk can also be defined as the intentional interaction
with uncertainty (potential, unpredictable and
uncontrollable outcome)
- Risk analysis covered:

• business risk
• financial risk
• insolvency risk
OVERVIEW OF RISK ANALYSIS
- Factors lead to enterprise’s risk:

• The changes in governmental policy, economic crisis
• The changes of market, customers’ behavior
• Natural disaster, the development of scientific and
technology
J4.1
BUSINESS RISK ANALYSIS
• Definition: business risk is the risk coming along with

uncertainty, fluctuation in the company’s performance
and operating efficiency. The business performance and
operating efficiency are presented by indicators: sales,
profit, ROA, RE…
• Business risk assessment:

o Variance, standard deviation, coefficient of variation
o The degree of operating leverage/risk ratio

Variance: The variance is one of the measures of

dispersion, that is a measure of by how much the values in
the data set are likely to differ from the mean of the values
n
Var (k )   2   (k i  kˆ) 2 p i
i 1
n
kˆ   p i k i : expected value/mean of indicator : sales,
i 1
profit, ROS, ROA, ROE…
Ki : value of indicator
Pi : probability to get the value of indicator Ki
Variance, standard deviation, coefficient of variation:
n
Var (k )   2
  (k i  k ) p i
ˆ 2
i 1
n
   i
(k 
i 1
ˆ) 2 p
k i

H bt 
kˆ
Illustration: ROAs of company A and B of the previous
years are shown in the following table. Compare business
risk of two companies using the dispersion of ROA
(assumed that probability to get the value of ROA in
every quarter is the same)
Quarter I Quarter II Quarter III Quarter IV
ROA (Co A) 2 4 5 3
ROA (Co B) 21 20 25 18
Variance standard deviation coefficient of variation

Co A 3.5% 1,118 0,32
Co B 19.5% 1,118 0,057
- The degree of operating leverage:
% change in operating profit Total CM

DOL = =
% change in sales Total CM - TFC
• Operating leverage is a measure of how revenue growth

translates into growth in operating income (measures the
sensitivity of a company's profit to fluctuations in its sales)
• The higher the degree of operating leverage, the more
volatile and unpredictable the EBIT figure is relative to a
given change in sales, assuming all other variables remain
constant.
- The degree of operating leverage exposed some

determinants of risk:
• The level of fixed costs

• The change of input cost and the ability of cost control
• The ability to adjust the selling price when the cost of
input changes
• The change of market demand
The impact of fixed cost on DOL might be mostly

significant; it is related to the company’s investment rate.
DOL is also called as the fixed-cost leverage
- Risk ratio:
Sales
Risk ratio =
Sales – break even sales
illustration
Co A Co B
Sales 200.000 200.000
Total variable cost biến phí 140.000 30.000
Contribution margin 60.000 170.000
Total fixed cost định phí 30.000 140.000
Profit (EBIT) 30.000 30.000
The degree of operating leverage:
60.000 170.000
Co A: = 2 Co B: = 5,67
30.000 30.000
illustration
Scenario 1: sales increase by 20%

∆profit A =
∆ profit B =
Scenario 2: sales decrease by 20%

∆ profit A =
∆ profit B =
FINANCIAL RISK ANALYSIS
The degree of financial leverage (DFL)
% change in ROE
DFL =
% change in EBIT
The degree of financial leverage (DFL) measures the

sensitivity of a company's ROE to fluctuations in its
operating income, as a result of changes in its capital
structure
% change in ROE
DFL =
% change in EBIT
(EBIT – interest expense) (1 - T)

ROE = Owner’s equity
(∆EBIT - ∆ IE) (1 - T) ∆EBIT (1 - T)

∆ROE =
Owner’s equity
= Owner’s equity
∆EBIT (1 - T)
∆ROE ∆EBIT
Owner’s equity
= (EBIT - IE)(1 - T) =
ROE (EBIT - IE)
Owner’s equity
∆EBIT
P before tax +
EBIT
(EBIT - IE) interest expense
DFL = ∆EBIT = =
(EBIT - IE) P before tax
EBIT
INSOLVENCY RISK
• Short-term liquidity risk

• Long-term solvency risk
• Credit rating
• Altman Z-score – bankruptcy prediction model
INSOLVENCY RISK
• Liquidity refers to an enterprise's

ability to pay short-term
obligations.
• Solvency refers to an enterprise's
capacity to meet its long-term
financial commitments.
SHORT-TERM LIQUIDITY RISK
- Current liabilities coverage ratio

- Working capital turnover
SHORT-TERM LIQUIDITY RISK
- Current liabilities coverage ratio:
Current assets
Current ratio =
Current liabilities
Current assets – Inventories – other current assets

Quick ratio =
Current liabilities
Cash & cash equivalents

Cash ratio =
Current liabilities
Net cash flow from operations
Cash flow ratio =
Current liabilities
SOLVENCY RISK
- Working capital turnover:
Cost of goods sold
Inventory turnover = Average inventories
360
Inventory turnover period = Inventory turnover
Sales + VAT output

Accounts receivable
turnover = Average accounts receivable
360
Accounts receivable
= Accounts receivable
turnover period
turnover
LONG-TERM SOLVENCY RISK
- Debt ratios
- Interest coverage ratios
- The ability to generate cash from operating
activities, investing activities and financing
activities
- Debt ratio:
Total liabilities
Liabilities to assets ratio =
Total assets
Total liabilities
Liabilities to shareholder’s
=
equity ratio Total shareholder’s equity
Long-term debt
Long-term debt to
long-term capital = Long-term debt + Total shareholder’s equity
ratio
Long-term debt
Long-term debt to
=
shareholder’s equity ratio
- Interest coverage ratio
Profit before tax + interest expense

Interest
coverage ratio =
interest expense
Net cash flow from operations

= + payment for interest and income taxes
Cash payment for interest
CREDIT RATING
- A credit rating is an evaluation of the credit risk of a

prospective debtor, predicting their ability to pay back
the debt, and an implicit forecast of the likelihood of the
debtor defaulting.
+ Based on credit rating agencies (Moody, Standard and
Poor…..)
+ Altman z-score for predicting bankruptcy
CREDIT RATING
- Moody’s J4.2
- Fitch Ratings
- Standard and Poor’s
+ established in 1860, US
+ S&P 500, S&P Global 1200, S&P Vietnam 10
J4.3
ALTMAN Z-SCORE
- Bankruptcy prediction model : Edward I. Altman in 1968
- (born 1941) is a Professor of Finance,

Emeritus, at New York University’s Stern
School of Business
- Altman holds a B.A in Economics, (CCNY,
1963); an MBA ( UCLA, 1965); and
a Ph.D in finance (UCLA, 1967)
- Altman is the author, co-author, or editor of
25 books
- He was named one of the "100 Most
Influential People in Finance" by the Treasury
& Risk Management magazine in 2005
ALTMAN Z-SCORE
- Bankruptcy prediction model :
For a public company:
Z = 1,2T1 + 1,4T2 + 3,3T3 + 0,6T4 + 1,0T5
T1= Net working capital/total assets (measure of liquidity)

T2= Retained earnings/total assets (measure of cumulative profitability)
T3= EBIT/total assets (measure of return on assets)
T4= market value of equity/book value of total liabilities (measure of
market leverage)
T5= Sales/total assets (measure of sales generating potential of assets )
ALTMAN Z-SCORE
- If Z > 2.99: “non-bankrupt sector”
- If 1,81<Z < 2.99: “gray area”
- If Z < 1.81: “bankrupt sector”
* Z” = 3,25 + 6,56X1 + 3,26X2 + 6,72X3 + 1,05X4

Z’’ adjustment S&P Moody’s
> 8,15 AAA Aaa

7,60 – 8,15 AA+ Aa1
7,30 – 7,60 AA Aa2
7,00 – 7,30 AA- Aa3
Safe area 6,85 – 7,00 A+ A1
Investable
6,65 – 6,85 A A2
6,40 – 6,65 A- A3
6,25 – 6,40 BBB+ Baa1
5,85 – 6,25 BBB Baa2
5,65 – 5,85 BBB- Baa3
5,25 – 5,65 BB+ Ba1
4,95 – 5,25 BB Ba2 High risk
Gray area
4,75 – 4,95 BB- Ba3
4,50 – 4,75 B+ B1
4,15 – 4,50 B B2
3,75 – 4,15 B- B3
3,20 – 3,75 CCC+ Caa1 Should not
invest
Dangerous area 2,50 – 3,20 CCC Caa2
1,75 – 2,50 CCC- Caa3
0 – 1,75 D
CASH FLOW BASED RATIOS
CFO
CFO to current liabilities =
Average current liabilities
CFO
CFO to total liabilities =
Average total liabilities
CFO + interest expense

CF-interest coverage =
interest expense
dividends
Dividend payout of cash from
=
operating activities CFO

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CHAPTER IV

THE RISK ANALYSIS

- Risk is the potential of gaining or losing something of

- Risk analysis covered:

- Factors lead to enterprise’s risk:

• The changes of market, customers’ behavior

• Natural disaster, the development of scientific and

• Definition: business risk is the risk coming along with

• Business risk assessment:

o The degree of operating leverage/risk ratio

Variance: The variance is one of the measures of

Variance, standard deviation, coefficient of variation:

Variance standard deviation coefficient of variation

- The degree of operating leverage:

% change in operating profit Total CM

• Operating leverage is a measure of how revenue growth

- The degree of operating leverage exposed some

• The level of fixed costs

The impact of fixed cost on DOL might be mostly

The degree of operating leverage:

Scenario 1: sales increase by 20%

Scenario 2: sales decrease by 20%

The degree of financial leverage (DFL)

The degree of financial leverage (DFL) measures the

(EBIT – interest expense) (1 - T)

(∆EBIT - ∆ IE) (1 - T) ∆EBIT (1 - T)

• Short-term liquidity risk

• Liquidity refers to an enterprise's

- Current liabilities coverage ratio

Current assets – Inventories – other current assets

Cash & cash equivalents

Sales + VAT output

Profit before tax + interest expense

Net cash flow from operations

- A credit rating is an evaluation of the credit risk of a

- (born 1941) is a Professor of Finance,

Z = 1,2T1 + 1,4T2 + 3,3T3 + 0,6T4 + 1,0T5

T1= Net working capital/total assets (measure of liquidity)

- If Z > 2.99: “non-bankrupt sector”

- If 1,81<Z < 2.99: “gray area”

- If Z < 1.81: “bankrupt sector”

* Z” = 3,25 + 6,56X1 + 3,26X2 + 6,72X3 + 1,05X4

> 8,15 AAA Aaa

CFO + interest expense

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