Other Financial Risk Measures - Financial Management

In addition to using various financial ratios and the degree of combined leverage as measures of the financial risk facing a firm, it is possible to make more formal statements about the financial risk facing a company if the probability distribution of future operating income (EBIT) is approximately normal and the mean and standard deviation can be estimated. The number of standard deviations, z, that a particular value of EBIT is from the expected value, EBIT, can be computed using an expression similar to Equation:


where s is the standard deviation of EBIT. Equation , along with the probability values from Table V in the back of the book, can be used to compute the probability that EBIT will be less than (or greater than) some particular value.

For example, consider the case of the Travco Manufacturing Corporation. Given the current capital structure of Travco, the company has interest payment obligations of $500,000 for the coming year. The company has no preferred stock. The $500,000 in interest represents the loss level for Travco. If EBIT falls below $500,000, losses will be incurred (EPS will be negative). At EBIT levels above $500,000, Travco will have positive earnings per share.

Based upon past experience, Travco’s managers have estimated that the expected value of EBIT over the coming year is $700,000 with a standard deviation of $200,000 and that the distribution of operating income is approximately normal, as illustrated in Figure. With this information, it is possible to compute the probability of Travco having negative earnings per share over the coming year (or, conversely, the probability of having positive earnings per share).

Probability distribution of EBIT travco manufacturing company

Using Equation , the probability of Travco having negative EPS is equal to the probability of having EBIT below the loss level of $500,000, or

z = $500,000 – $700,000/$200,000 = -1.0

In other words, a level of EBIT of $500,000 is 1.0 standard deviation below the mean. From Table , it can be seen that the probability associated with a value that is less than or equal to 1.0 standard deviation below the mean is 15.87 percent. Thus, there is a 15.87 percent chance that Travco will have negative earnings per share (i.e., the shaded area in Figure) with its current capital structure. Conversely, there is an 84.13 percent chance (100 percent less 15.87 percent chance of losses) of having positive earnings per share.

This type of analysis can give a financial manager a better feel for the level of financial risk facing a firm. As we shall see later in the chapter, when a financial manager is considering two or more alternative capital structures, this same kind of analysis can be used to help select the most desirable capital structure.

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