Analyzing Financial Risk

How much of financial risk is acceptable to investors largely depends on how low or high is a company’s business risk. For instance, grocery chains generally have stable operating income, which means low business risk, and which also means that investors and credit rating companies are likely to accept more financial risk.

However, if a company operates in a cyclical industry, such is, for example, the airline industry, such a company would likely have unstable sales and earnings, and thus high business risk. If high financial risk is also added to the equation, the two types of risk could compound exponentially and increase dramatically the possibility of bankruptcy.

Balance Sheet Ratios

Balance sheet ratios, also referred to as the proportion-of-debt ratios, demonstrate how much of a company’s capital results from debt in comparison to other sources of capital, such as the company’s retained earnings or stockholders’ equity. The rule of the thumb is the higher the proportion of debt-derived capital, the higher the earnings volatility. One of the more popular among the balance sheet ratios is the debt-to-equity ratio, and it is calculated as follows:

Debt-to-Equity Ratio = Total Long-Term Debt / Total Equity

Note that the ratio’s numerator includes all debt, including subordinated convertible bonds. Furthermore, total equity is typically calculated at book values and it includes retained earnings, common and preferred shares, although some analysts prefer not to include the last component in their analysis.

There are two more considerations that must be explored when analyzing debt-equity ratios: deferred taxes and operating leases. There is an ongoing controversy regarding whether deferred taxes should be treated as liabilities or as part of the capital structure. Leaving aside accounting theories for the moment, for purely analytical purposes, a more conservative approach is recommended, which is to treat deferred taxes as liabilities that would have to be paid off eventually.

The second concern is the treatment of operating leases, which goes along the same line of reasoning, or lack thereof, as the treatment of deferred taxes. Notably, the more conservative approach would be to treat the present value of lease payments not as current liabilities, but as long-term debt.

Cash Flow – Outstanding Debt Coverage Ratios

This type of ratios establishes the relationship between a company’s cash flows and its outstanding debt. The cash flow – outstanding debt ratios are also rather unique because they have been used extensively to estimate credit ratings, as well as to predict potential bankruptcies.

Cash Flow – Long Term Debt Ratio = Operating Cash Flow / Total Long Term Debt

Note that the total long-term debt includes the book value of the company’s long-term obligations, as well as the present value of its lease obligations. Some analysts also prefer to add interest-bearing current liabilities.

Cost-of-Debt Coverage Ratios

There are two cost-of-debt ratios to consider: the interest coverage ratio and cash flow coverage of fixed financial cost.

The interest coverage ratio demonstrates how many times the fixed interest charges are covered by earnings from operations. Or, deducting the interest coverage ratio from 1 demonstrates at what breaking point earnings could no longer satisfy interest expenses. For example, an interest coverage ratio of 5 means that a company’s earnings could decline by as low as 80% (since 1/5 = 0.20; then 1 – 0.20 = 0.80 or 80%) and the company could still meet its fixed debt obligations.

Interest Coverage = Income before Interest and Taxes (EBIT) / Interest Expenses

In addition, the reasoning behind the cash flow coverage of fixed financial cost is that a company’s earnings and cash flows are likely to differ considerably. This is because information on the statement of cash flows does not show the “beautified” picture, but simply the money that came in and the money that came out from operations, financing and investment activities. As part of the operating section, the statement of cash flows will also include items such as depreciation expenses, deferred taxes, etc., and show how those impacted the company’s working capital.

Cash Flow of Fixed Financial Cost = (Operating Cash Flow + Interest Expense + Implied Lease Interest) / (Interest Expense + Implied Lease Interest)

This concludes the two-part series on risk analysis. To read the first part, please use the following link.

Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005.

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