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.