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Financial Risk Cheat Sheet by

CPCU500_CH.7_Study_Guide

Financial Risk

Risk Management in Finance

Risk Manage­ment: The process of identi­fic­ation, analysis, and acceptance or mitigation of uncert­ainty in investment decisions.
A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statis­tical measure of dispersion around a central tendency.
Market risk, is a measure of the volati­lity, or systematic risk, of an individual stock in comparison to the entire market.

FINANCIAL RISK RATIOS

Net Income
= (Total Revenue + Gains) – (Total Expenses + Losses)
Working Capital
= Current Assets - Current Liabil­ities

MARKET VALUE RATIOS

Book Value per Share ratio = (Share­hol­der’s equity – Preferred equity) / Total common shares outsta­nding
calculates the per-share value of a company based on the equity available to shareh­olders
Dividend Yield ratio = Dividend per share / Share price
measures the amount of dividends attributed to shareh­olders relative to the market value per share
Earnings per Share ratio = Net earnings / Total shares outsta­nding
measures the amount of net income earned for each share outsta­nding
Pric­e-E­arnings ratio = Share price / Earnings per share
compares a company’s share price to its earnings per share
Market Value Risks - are used to evaluate the share price of a company’s stock.

LIQUIDITY RATIOS

Acid­-test ratio = (Current assets – Invent­ories) / Current liabil­ities
measures a company’s ability to pay off short-term liabil­ities with quick assets
Current ratio = Current assets / Current liabil­ities
measures a company’s ability to pay off short-term liabil­ities with current assets
Cash ratio = Cash and Cash equiva­lents / Current Liabil­ities
measures a company’s ability to pay off short-term liabil­ities with cash and cash equiva­lents
Oper­ating cash flow ratio = Operating cash flow / Current liabil­ities
measure of the # of times a firm can pay off current liabil­ities w/ the cash generated in a given period
Liquidity Ratios: financial ratios that measure a company’s ability to repay both short- & long-term obliga­tions

LEVERAGE RATIOS

Debt Ratio = Total liabil­ities / Total assets
measures the relative amount of a company’s assets that are provided from debt
Debt to Equity ratio = Total liabil­ities / Shareh­older’s equity
calculates the weight of total debt and financial liabil­ities against shareh­olders’ equity
Interest Coverage ratio = Operating income / Interest expenses
shows how easily a company can pay its interest expenses
Debt Service Coverage ratio = Operating income / Total debt service
reveals how easily a company can pay its debt obliga­tions
Leverage Fianance Ratios: measure the amt of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels.

PROFIT­ABILITY RATIOS

Gross margin ratio = Gross profit / Net sales
compares the gross profit to its net sales to show how much profit it makes after paying its cost of goods sold
Oper­ating margin ratio = Operating income / Net sales
compares the operating income of a company to its net sales to determine operating efficiency
Return on assets ratio = Net income / Total assets
measures how effici­ently a company is using its assets to generate profit
Return on equity ratio = Net income / Shareh­older’s equity
measures how effici­ently a company is using its equity to generate profit
Profit­ability Ratios­:me­asure the ability to generate income relative to revenue, balance sheet assets, operating costs, and equity.

EFFICIENCY RATIOS

Asset Turnover ratio = Net sales / Average total assets
measures a company’s ability to generate sales from assets
Inve­ntory Turnover ratio = Cost of goods sold / Average inventory
measures how many times a company’s inventory is sold and replaced over a given period
Rece­ivables Turnover ratio = Net credit sales / Average accounts receivable
measures how many times a company can turn receiv­ables into cash over a given period
Days Sales in Tnventory ratio = 365 days / Inventory turnover ratio
measures the average # of days that a company holds on to inventory before selling it to customers
Efficiency Ratios (aka activity financial ratios): are used to measure how well a company is utilizing its assets and resources.
 

Types of Risks

Fina­ncial Risk: Specul­ative risk associated with the effects of market forces on financial assets &/or liabil­ities.
Market Risk: Risk of losses in positions arising from movements in market prices.
(3) types of market risk: Interest rate risk; Exchange Rate risk; and Liquidity risk
Interest Rate Risk: Uncert­ainty over changes in interest rates and the effect of those changes on a security's future value. the risk that a security's future value will decline b/c of changes in interest rates.
Exchange Rate Risk: Risk arises when there is a risk of an unfavo­rable change in exchange rate btwn the domestic currency & denomi­nated currency. changes in the exchange rate will affect the value of a firm's assets and liabil­ities.
Credit Risk: The risk that customers or other creditors will fail to make promised payments; it can be relevant to any org w/ accounts receiv­able.
Coun­ter­party Risk: The risk that the other party to an agreement will default. (aka Credit risk)
Price Risk: Uncert­ainty over the size of cash flows resulting from possible changes in the cost of raw materials & other inputs (such as lumber, gas, electr­icity), as well as cost-r­elated changes in the market for completed products.
Output Price Risk: The price charged for the firm's products or services.
Input Price Risk: The price of resources used to make the firm's products.
Inve­stment Risks include: Inflation Risk, Maturity Risk, Default Risk, Liquidity Risk
Liqu­idity Risk: A financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price. repre­sents uncert­ainty about the ability to convert an investment to cash quickly w/ little loss of principal (within a short time period and a small price range).
Infl­ation Risk: Risk associated w/ the loss of purchasing power b/c of an overall increase in the economy's price level.

Securities & Other Contracts

Secu­rit­iza­tion: the procedure of pooling various types of contra­ctual debt & selling their related cash flows to a 3rd party investor as securi­ties. Secur­iti­zation offers opport­unities for investors and frees up capital for origin­ators, both of which promote liquidity in the market­place.
Securi­tiz­ation transa­ctions use Special Purpose Vehicle (SPV) facilities establ­ished to:
1. Buy income producing assets.
2. Use those assets to collat­eralize securi­ties.
3. Sell securities to investors.
Secu­rit­ies: a tradable financial asset. Refers to any form of financial instrument repres­enting either money or other property, such as stocks­/bonds.
1. Debt Securities - ex› banknotes, bonds, debent­ures.
2. Equity Securities - ex› Common stocks.
3. Deriva­tives - ex› forwards, futures, options, swaps
Deri­vative Contra­cts: Securities with values that depend on values of other assets. contracts btwn 2 parties that specify conditions under which payment are to be made. / Contract derives its value from the perfor­mance of an underlying entity.
Hedg­ing: Protecting against cost increases with contracts that allow a company to buy supplies in the future at designated prices. a financial transa­ction in which (1) asset is help to offset the risk associated with another asset.
Corr­ela­tion: in the finance and investment indust­ries, is a statistic that measures the degree to which two securities move in relation to each other. Correl­ations are used in advanced portfolio manage­ment, computed as the correl­ation coeffi­cient, which has a value that must fall between -1.0 and +1.0.

Financial Statements

Balance Sheet: A balance sheet is a financial statement that reports a company's assets, liabil­ities and shareh­olders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareh­olders.
Income Statem­ent: Also known as the profit and loss statement or the statement of revenue and expense, the income statement primarily focuses on the company’s revenues and expenses during a particular period.
Fina­ncial statem­ents are written records that convey the business activities and the financial perfor­mance of a company.
Financial statements include: Balance sheet / Income statement / Cash flow statement.

Assets

Capi­tal: Capital is a term for financial assets, such as funds held in deposit accounts and/or funds obtained from special financing sources. Capital can also be associated with capital assets of a company that requires signif­icant amounts of capital to finance or expand.
Fina­ncial Asset: A financial asset is a liquid asset that gets its value from a contra­ctual right or ownership claim. Ex. incl: Cash, stocks, bonds, mutual funds, and bank deposits.
financial assets such as stocks and bonds, which derive their value from contra­ctual claims, are considered tangible assets.
Inta­ngible Asset: an asset that is not physical in nature. Goodwill, brand recogn­ition and intell­ectual property, such as patents, tradem­arks, and copyri­ghts, are all intangible assets. Intangible assets exist in opposition to tangible assets, which include land, vehicles, equipment, and inventory.
Intan­gible assets created by a company do not appear on the balance sheet and have no recorded book value.
Retained Earnin­gs: Net income retained by the firm after payment of the dividends and taxes.
Assets: Current & Non-Current:
Current Assets: cash or assets likely to be converted to cash or consumed within 1 yr.
ex› Cash, Marketable securi­ties, Receiv­ables (accounts & notes), Invent­ories, Prepaid expenses.
Non-­Current Assets: will be used over a period greater than 1 yr.
*cannot easily be converted into cash. ex› Tangible - land; buildings, equipment; Intangible - patent; copyright; trademarkl intell­ectual property.

Liabil­ities | Debt

Shor­t-Term Debt: aka current liabil­ities, is a firm's financial obliga­tions that are expected to be paid off within a year. It is listed under the current liabil­ities portion of the total liabil­ities section of a company's balance sheet.
Long­-Term Debt: debt that matures in more than one year. Long-term debt can be viewed from two perspe­ctives: financial statement reporting by the issuer and financial investing. In financial statement reporting, companies must record long-term debt issuance and all of its associated payment obliga­tions on its financial statem­ents. On the flip side, investing in long-term debt includes putting money into debt invest­ments with maturities of more than one year.
Long-term debt liabil­ities are a key component of business solvency ratios, which are analyzed by stakeh­olders and rating agencies when assessing solvency risk.
Debt­-To­-Equity Ratio – (D/E): is calculated by dividing a company’s total liabil­ities by its shareh­older equity. These numbers are available on the balance sheet of a company’s financial statem­ents.
The ratio is used to evaluate a company's financial leverage.
Leverage Ratio: Any one of several financial measur­ements that look at how much capital comes in the form of debt (loans) or assesses the ability of a company to meet its financial obliga­tions.
A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income.
Depr­eci­ati­on: the allocation of a noncurrent tangible asset value over time. Expense generated by the uses of the asset.
Liab­ili­ties: Current & Noncur­rent:
Current Liabil­iti­es: debts to be settled within the fiscal yr (1 yr).
ex› Accounts payable; Short term debt; Accrued expenses such as wages payable, interest payable, and taxes payable.
Nonc­urrent Liabil­ities - (long term liabil­ities) not due and payable within 1 yr, will not be satisfied more than 1 yr after the balance sheet date.
ex› long term notes payable.
Shar­eho­lders' Equity (Owners' Equity): Listed on the liabil­ities side of the balance sheet b/c a firm does not own its net worth, but rather owes it to its owners.
Liqu­idity Risk: A financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Following ratios can be considered to measure the liquidity of a firm: Working Capital; Working Capital Ratio; Current Ratio; Quick Ratio; and Absolute Liquid Ratio.
Current Ratio: A liquidity ratio that measures whether a firm has enough resources to meet its short-term obliga­tions. high ratio indicates high liquidity and, possibly, an ineffi­cient use of resour­ces.
Quick Ratio (Acid-Test Ratio): Type of liquidity ratio, which measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabil­ities immedi­ately. A more conser­vative assessment of the liquidity position than current ratio, as it excludes inventory - low ratio may indicate a too large inventory, which reduces liquid­ity.
Debt to Assets Ratio (Debt ratio): A Leverage Ratio that shows the extent to which the firm's assets are financed by debt. High ratio indicates a company that is highly leveraged (used borrowed money to invest) and may be trouble making its debt payment.
Coll­ate­ral­ize: The act of pledging an asset, like real property, to secure a loan or investment providing recourse in the event of default.
Subprime Borrow­er: A type of borrower who has low credit rating or a limited credit history.

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