Friday, January 17, 2014

Risk Outline: Accounting for Lawyers

Risk Outline: Accounting for Lawyers
  • Factors that affect risk:
    • Economy-wide factors, such as credit crisis, a recession or inflation
    • Industry wide factors, such as obsolescence or competition
    • Firm-specific factors such as the potential for a labor strike and poor management
  • Generally focuses on relative liquidity of firm:
    • Short-term risk: can firm pay short-term obligations, such as wages?
      • Working capital: current assets – current liabilities
        • Expressed as money amount
      • Current ratio: current assets/current liabilities
        • Expressed as a ratio; rule of thumb = 1.5
      • Acid-test/Quick ratio:
        • (cash + ST investments + net receivables)/current liabilities
        • More stringent measure than the current ratio
        • Expressed as ratio; rule of thumb = 0.9 – 1.0
      • Current ratio (aka working capital ratio)
        • Measure of company’s ability to pay its current liabilities
        • = total current assets/ total current liabilities
        • = (cash + ST investments + net receivables + inventories + prepaid expenses) / total current liabilities
    • Long-term risk: can the firm pay long-term obligations, like debt?
      • Debt-to-equity:
        • = total liabilities/total equities
        • Percentage of total financing provided by debtors or creditors
      • Debt ratio:
        • = total liabilities/total assets
        • Proportion of the assets that are financed with debt
          • Average for most companies = 0.62
        • The higher the ratio, the greater the pressure to pay the debt
      • Times Interest Earned
        • Income from operations/interest expense
        • Measures the number of times interest can cover interest
        • High ratio indicates the ease of paying interest
      • Cash from operations/total liabilities
        • Measures the ability of the firm to pay all liabilities from cash without new debt or additional investment
  • Liabilities on Cash Flow Statement
    • Issuing bonds, short- and long-term debt are reported as financing inflows
    • Repayment of bond and loan principal are financing outflows
    • Interest expense is classified as operating outflow
    • Capital lease: financing inflow, investing outflow
  • Stock investments
    • Price-earnings ratio
      • Market price per share of common stock/earnings per share
      • Compares market price to earnings
      • Investors prefer low P/E ratio to high one
    • Dividend yield
      • Dividend per share/market price per share
      • Compares dividends per share to market price
    • Book value per share
      • (Total shareholders’ equity – preferred equity)/(# of common shares outstanding)
  • Limitations of Ratio Analysis
    • Ratios based on financial data share the same problems of financial data (such as timeliness).
    • Changes in many ratios correlate with other ratios, so a direct interpretation of a change in ratio is not always apparent.
    • Comparing ratios over time is complicated by the fact that economic conditions may change also.
    • Comparing ratios between two firms is complicated by the fact that the firms may hve different economic environments or production technologies even though they produce same product.

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