Post on 27-Mar-2015
transcript
It is to determine risk from the balance sheet
Presented by:Priscilla Wong (97001051)Carmen Wong (97001303)
Carly Wong (97006010)
OutlineWhat is Balance Sheet?Use of Balance SheetWhat is risk?Types of risk we would talk aboutPossibility to determine risk from Balance SheetConclusionSources to determine risk
Balance SheetFinancial statement of positionList of all assets, liability & owner’s equityA single date, not a period of timeOne of the main documents legally required to be produced by companies as part of the annual report
Use of Balance SheetProvide information to assess the financial position at a particular point in timeSummarize information in a clear & intelligible formClassify items in an appropriate manner to show the strength of the enterpriseIndicate relative liquidity of assets & liabilityEvaluate financial position at a particular point of time
Question of Balance Sheet
Is it information in Balance Sheet useful to investor and other users?
Investors concernRational investors must consider:
expected return expected risk
for a given level of expected return, an investor will seek to minimize risk for a given level of expected risk, an investor will seek to maximize return
Expected ReturnIt can be obtained from the financial statement easily
For example, net income can be obtained from balance sheet from the change in retained earning
Expected RiskBut
Balance Sheet does not reflect any risk information directly
Risk“ Risk & financial reporting: A summary of the
discussion at the 1997 AAA/FASB conference” Risk is difficult to define because different financial users value information about different types of riskProbability that events will differ from what has predicted
risk is unforeseen Risk is difficult to assess due to uncertainty
Types of Risk
Business Risk (external)Operating Risk (internal)
Financial Risk (numerical)
Business Risk
Risk related to the company’s industryExternal to the business entity itselfInfluence on the entityNature of the business
Business RiskTechnology faced by the companyAvailability of product substitutesLevel of domestic and international involvementRobustness of demand for productsOverall diversification policyCapital/labour mixture
Business RiskRelations with trade unionsSize and wealthReputation of name and productExtent and nature of government interventionNature of legislation facedImpact on the physical environment Growth
Business RiskDifficult to quantifySubjective to each personRisk on the other hand may be chance
Help development of business in the futureNot appear in Balance Sheet
can’t be measured by Balance Sheet
Operating RiskRisk associated within the operation of the companyDifferent form the business risk Business risk related to the nature of the industryOperating risk related to the operation of that specified firm
Operating RiskFor example,
employee royalty turnover rate hinder operation recruit new people require time and
training sales and profit Risk
Operating Risk
If the major customer is lostFinancial difficulty may be resulted
We are encountering a financial problem… may go into liquidation…
Operating RiskOld production process
Ineffective for productionCost & fail to meet customer
demand on timeCustomer switch to other supplierSale and profitrisk
Operating RiskOperating activities of management related to the performance of the company directly change the investment decision of investors
However,Investors cannot obtain the operating information from the balance sheet easilyReason: information asymmetry
Operating RiskOperation risk is difficult to assess
Not enough information Difficult to quantify objectivelyUncertain about the time and amount of possible financial loss
Not easy to determine
Financial Risk
Risk imposed on the business by the use of debt finance (capital structure)
Related to the numerical data
Financial RiskConsider the capitalization structure
Ability to service existing structureSufficient profits to protect debt covenant violationSufficient cash to pay interest when due and dividend
Ability to maintain or alter present structure
Maintain present dividend policyIssue new securities
Financial RiskNumber itself may not reflect risk directlyMeasured by:
financial ratiostrend analysis
Financial RatioCurrent ratio = current assets/current liabilities
Quick ratio= (current assets –inventory)/current liabilities
The lower of current ratio & quick ratio financial risk not enough liquid asset to meet the debt
obligation
Financial Risk
Total debt ratio= total liabilities/total assets
The higher of total debt ratio financial risk the capital structure of firm is not so sound
Financial RatioDividend pay out ratio
= Dividend/Retained profitThe lower the dividend pay out ratio
financial risk not enough cash to pay out the
dividend
Financial RatioFinancial leverage
= total debt/total equityThe higher the gearing ratio financial risk use too much debt to finance its
operation pay huge amount of interest may not able to repay the debt
Financial RatioHowever…Short-term debt finance long term assets?Current assets really convertible into cash?Ratios calculated as on the balance sheet date timely to show the financial situation of the company now?
Problem of interpretation as income statement information is not taken into account
Trend AnalysisTechnique used for time periods in excess of 2 or more years Make results easier to understand and interpretProjection of the accounting figures indicate the risk faced by the company
Trend AnalysisImpacts of changes in technology on price of assets not reflectedSome assets depreciates faster, e.g. computersBut, consistent depreciation policy is appliedUndervaluation of assets
Risk associated with technology changes
can’t be assessed through balance sheet!!
Trend AnalysisImpacts of industry environment not reflected in Balance SheetBalance sheet reflects information of one company, not whole industrySuperior performance may not be due to good performance of that company, but due to the good performance of the whole industry
Trend Analysis
Accounting policies not applied consistentlyComparison not availableInterpretation misleading
Trend AnalysisFinancial information across companies within same industryDifferent company different size, different risks, different accounting policies comparison meaningless risk wrongly assessed
ConclusionRisk is very difficult to measure from Balance Sheet only because:
Balance sheet does not have sufficient information to measure risk
Balance sheet show a particular point of time only
Bias More complete risk measurement together with income statement and cash flow statement for financial risk
ConclusionNot every risk can be quantified objectivelyRisk full of uncertainty
When and how much the risk would happen
Difficult to determine risk
Determination of risk from Balance Sheet
Sources to Determine RiskGovernment Statistics
overall economic situation & industry situationTrade journals
the general situation of the overall industry
Growing? Declining?
More understanding on the industry assists more
accurate risk determination.
Sources to Determine RiskAnnual reportIncome statement & Cash flow statement & Balance Sheet:Financial informationOverall performanceprediction of future risk more accurately
Sources to Determine RiskAnnual report:Chairman’s StatementDirector’s report
the forthcoming challenges the firm is ready to face
company’s confidence towards the challenges
Sources to Determine RiskManagement behaviourchange in dividend policyE.g. Sudden drop in common dividend to zeroFailure to cover preferred dividends company short of cash