Overview

Selecting the Financial Data tab on the main screen displays the following screen.

The following functions can be performed.

• financial data . This sub-module enables you to record balance sheets and income statements for the number of years specified on the client screen. Once the data has been recorded, the module identifies all changes in excess of materiality during the past year and requests explanations for them. These explanations are recorded in the system output.
• significant fluctuations . After you have recorded the Financial Data, Risk Alert will search the balance sheet and income statement for items that display significant fluctuations (changes greater than materiality).
• account aging ). These screens are used to record the percentage of accounts payable or receivable at the various aging levels. The columns should sum to 100 percent. If the sum of any column is not equal to 0 or 100, a warning is issued.
• ratios . The ratio analysis sub-module calculates various measures of financial performance divided into major categories of indicators and displays the results on the screen, using colour-coding to highlight potential problems. The user is asked to concur with or challenge the overall conclusion based on the analysis of financial indicators. The user's assessment is stored and reported in the system output.
• distress models. This sub-module calculates financial distress scores based on leading financial distress prediction models.
• unsustainable sales growth . Increasing sales is generally considered to be a positive sign; however, according to some finance literature, pursuit of unsustainable growth is one of the main managerial errors that often leads to business failure. The argument made in this regard is that preoccupation with growth at any cost will overextend an entity administratively and financially. This can lead to a decline in profitability, cash shortages and other difficulties, sending the entity into a downward spiral.
• market value of the firm’s stock . Finance theory suggests that the risk of bankruptcy is related to the variability of security returns. A highly variable stock price will go through "boom-bust" phases, reflecting both a high potential of abnormal returns and a high risk of ruin.

An important first step in applying Risk Alert is recording key financial data for the entity, including balance sheet and income statement figures.

Data can be directly recorded in the cells. Clicking on the small calculator icon at the right of a cell will pop-up a calculator which can be used to perform simple computations when entering data in a cell. Risk Alert displays a warning on the financial data menu screen when the balance sheet does not balance.

After you have recorded the Financial Data, Risk Alert will search the balance sheet and income statement for items that display significant fluctuations (changes greater than materiality). For each item found that has a significant fluctuation, the following screen is displayed.

Risk is accumulated in proportion to the ratio of change to materiality unless the change is marked as expected or explainable. In that event, an explanation and the percentage of risk reduced can be recorded.

These screens are used to record the percentage of accounts payable or receivable at the various aging levels. The columns should sum to 100 percent. If the sum of any column is not equal to 0 or 100, a warning is issued.

Clicking on the ratios button on the Financial Indicators Menu screen displays the following screen:

The ratios are grouped into eight categories. Risk Alert computes a score for each of the categories based on the ratios in the category.

The ratios table displays the ratios computed using the financial data recorded for the client.

The entries in the table are colour-coded by comparing the ratios to industry data. If an entry falls in the bottom or fourth quartile for the industry, it is red; in the third quartile it is yellow; in the second quartile it is white; and in the top quartile it is green.

If trend calculations are enabled, trend values are computed for each indicator and colour-coded: red or yellow for decreasing, white for stable and green for increasing.

Each value and trend in the table is assigned a value based on its colour-coding: -2 for red, -1 for yellow, 0 for white and 1 for green.

Risk Alert computes a rating for the category using these values in four ways and colour-codes the category based on the worst result. The four methods are:

• using the colour-codings for the current period only,
• using the colour-codings for all the periods available
• using the row summary for a ratio and
• using the colour-codings for the trends (if they are enabled).

The combined rating (also colour-coded) for each category is displayed on the Ratios Summary screen as well as the calculation result for each of the above four methods.

An overall financial rating for the entity is computed by aggregating the eight category ratings to arrive at an overall conclusion of poor, stable or good. You are given the option of agreeing or disagreeing with the analysis and recording an explanation if you disagree.

Selecting show graph from the graph menu displays a graphical representation of the data displayed in the table.

Clicking on the distress models button on the Financial Indicators Menu screen displays the following screen:

Distress models are mathematical computations which model the financial distress of a company based on research of other companies that are known to be in financial distress.

Risk Alert uses Canadian models developed by Altman and Levallee, Springate, and Legault and Verroneau.

Risk Alert uses US models developed by Altman, Ohlson, and Zmijewski.

The Financial Distress Prediction Models display shows the values computed for the three models for the current period as well as the trend of the three models over all the periods available. The model values are colour-coded red if they predict financial distress and green if they do not.

The results of the distress model analysis are used for computing the risk score for one indicator.

Clicking on the unsust. growth button on the Financial Indicators Menu screen displays the following screen:

Sales growth is generally considered to be a positive sign; however, according to some finance literature, pursuit of unsustainable growth is one of the main managerial errors that often leads to business failure. The argument made in this regard is that preoccupation with growth at any cost will overextend an entity administratively and financially. This can lead to a decline in profitability, cash shortages and other difficulties sending the entity into a downward spiral.

Risk Alert uses three sustainable growth models:

• growth beyond a sustainable limit calculated using a formula for identifying maximum sustainable sales growth.

• growth exceeding the target rate of return on beginning-of-year equity multiplied by the dividend retention rate.

• growth beyond a fixed percentage of sales. The percentage used can be modified by recording it in the box provided.
  This value defaults to 40% of the prior period sales.

Selecting the unsust. growth button from the Financial Indicators Menu displays a screen showing the sustainable growth values for the three models for the current period as well as the trend for the three models over the periods available. The sustainable growth values are colour-coded: green if the actual growth is less than the computed sustainable growth value and red if the actual growth is greater than the sustainable growth value. The results of the sustainable growth model analysis are used for computing the risk score for one indicator.

Clicking on the market value button on the Financial Indicators Menu screen displays the following screen:

Background

Finance theory suggests that the risk of bankruptcy is related to the variability of security returns.

A highly variable stock price will go through "boom-bust" phases, reflecting both a high potential of abnormal returns and a high risk of ruin. One study showed how an increase in the systematic risk (Beta, a widely-used measure of volatility of security returns) would not, on average, increase the probability of failure, whereas an increase in the unsystematic risk (measured as the variance of market model residuals) would lead to a significant increase in the probability of failure.

This is consistent with the findings of a study of business mortality which showed that Beta had very poor predictive ability for both favourable and unfavourable mortality, once the effects due to timing of announcements about pending mortality were controlled for. That study did find, however, that low security returns over a year (measured as price appreciation plus dividends compared to original purchase price) and high volatility (measured by the variance of daily returns) were strong predictors of unfavourable mortality in the following year.Some researchers have suggested that stock prices can signal increases in the risk of business failure earlier and more reliably than ratio analysis because the markets have access to information not reflected in financial statements. Since efficient markets seem to impound all available information into stock prices, including adjustments for "window dressing", they might be able to compensate for the ratio-distorting effects of deceptive accounting practices that might be used by entities experiencing financial distress. For example, studies show that shareholders of publicly-traded companies experience abnormal losses over periods of from four to six years prior to bankruptcy. Studies of bank failures in the US have found that stock prices signaled their deteriorating financial condition long before they were detected by government inspectors and long before the banks ultimately failed, despite the presence of financial manipulation.

The results of the stock performance analysis are used for computing the risk scores for three indicators.