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RISK ASSESSMENT THE NEW REALITY SHOW

Written by: Jim Adams

Article Overview: What is the range of risks in your investment

RISK ASSESSMENT THE NEW REALITY SHOW

As he tried to quench his
thirst ... he saw an image in the
pool, and fell in love with that
embodied hope, and found a
substance in what was only
shadow."
Narcissus
Continuing a theme started last month,
we are going to explore a method of using
spreadsheets that gives the end user
better insight into the risks going forward
in the business rather than the usual rosy
view that most portray.
THE PROJECT
On a recent assignment, we developed a standard
financial model with the usual balance sheet, cash
flow and income statement in a spreadsheet format.
The business had invested in a new facility, which it
had acquired for $10,000,000 in debt and we now
had to decide on the amount of equity required to
attract bank financing.
We took a less conventional approach in trying to
decide on the right amount of equity. For the main
cost and revenue drivers, rather than pick just one
value, we set up a range of values for each one so
that the spreadsheet picked a different value from
each of the ranges each time it ran. We then ran it
1000 times. The chart below shows the resulting
range of EBITDA values, showing a future that is
more of a distribution of probabilities than a march
forward to financial heaven.
We had good market data from the industry to set
the range of values for the main cost and revenue
drivers. We then increased the ranges on each side
to get a better feel for what could go wrong…..or
right.
WHERE IS THIS TYPE OF
ANALYSIS USEFUL?
· A company can look at the amount of equity
that it currently has, and determine in what percentage
of cases will it be adequate for the financial
metrics being imposed by its banks or
lenders. It can apply this analysis to any metric
for that matter.
· Venture Capitalists determining the appropriate
amount to invest and what percentage of the
company they should get in order to earn an acceptable
return.
· Treasurers determining the risks in investing in a
new plant or an acquisition.
· Project managers in bidding situations to determine
the likely probability of a potential project
being profitable, and then deciding whether to
submit a bid.
· Bank managers considering approval of a loan
might recommend the appropriate equity to be
invested prior to approving a loan.
THE ANALYSIS
We used the above type of approach to estimate
the following;
· The amount of equity that should be invested in
this business;
· The rate of return that could be expected in
most cases;
· The chances of several things going wrong at
once.
EQUITY REQUIRED
To estimate the amount of equity required, we set
the equity amount to ‘0’ to start and ran the spreadsheet
1000 times. We then looked at the generated
potential values for Current Assets, Current Liabilities,
Current Ratio and Bank Line. The first run
showed that 80% of the time the Current Ratio was
worse than our minimum target of 1.25.
The chart below shows the maximum amount of equity
required to meet the Current Ratio target of
1.25 in the percentage of cases shown. In other
words, if one invests $2.9 million in the business,
the current ratio target will be met in 95% of the
cases. In any exercise like this there will always be
outlying values that are much higher or lower than
the norm. As long as the equity is acceptable in the
vast majority of cases, then one should be satisfied
that the risk is adequately covered off.
We added the $2.9 million in equity to the spreadsheet
and ran the scenarios again. With the addition
of the equity, the current ratio was actually met
94% of the time. In further analyzing the data set
we took a look at Cash Flow Coverage and found
that prior to an equity injection it was only acceptable
78%% of the time based on a target ratio of
1.5. After the investment, the Cash Flow Coverage
was above 1.5 in 92% of the cases. We should now
satisfied that with an injection of $2.9 million that
the company would likely be onside with the lenders
and the bank.
RATE OF RETURN ON
INVESTMENT
To estimate the rate of return we will take a 5 year time
horizon from investment, and calculate it based on 5
times EBITDA plus the excess cash in the bank after paying
down the debt.
You can see that the majority of the returns are in
the 16-64% range which is adequate if you own
100% of the business. If you were asked to be less
than a 50% owner, it may not represent an attractive
rate of return based on the spread of risks
shown. This should give an investor, a better perspective
on what the range of returns might be on
an investment.
WHAT ARE THE CHANCES??
In our example there were three main cost drivers
accounting for 75% of the costs in this particular
business. What is the probability of all three cost
drivers going against the company at any one time?
We had a little over 8000 values in this sample set
and on 9 occasions all three cost drivers were at
their worst at the same tim e. Those are pretty
good odds!
CONCLUSION
This analysis can give the user greater insight into
the risks present in his business. However, it is in
the end, only a sophisticated “what if’ analysis and
is only as good as the ranges put in. Management
still counts and reality has a way of going beyond
what we thought were the widest of possible outcomes.
If unrealistic ranges are put in for the cost
and revenue drivers then you still run the risk of falling
love with your own reflection. We highly recommend
this type of analysis anytime that management
is considering a significant investment of resources.

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