Balance sheet obligations. Financial risk measures the capacity of a business to pay its creditors in the face of volatility. We understand financial risk by examining the balance sheet, the measure of a company's obligations versus its asset quality. Its profitability or earnings, the measure of the performance of a business. The cash flow, how a company generates cash to meet its obligations. Flexibility, withstanding fluctuations to deliver results. First, we need to accurately identify and quantify the existing and potential obligations, not just the short-term and long-term debt, but the project financing, the asset-backed securities, such as receivables and off-balance sheet items such as pensions and the debt of joint ventures. Second, we need to measure the quality of the assets. The age, stability, and cash flow generating ability. We need to understand how much leverage was used to acquire those assets. The first challenge in finding the debt on the balance sheet is to understand the various names that it can be called. Here's a partial list. You will become familiar with the various names as you look through more and more financial statements. The trickier part are the debt-like obligations, such as the pension obligations, the guarantees of the subsidiaries, JVs, or associate investments, the operating leases, which are now classified on the balance sheet as obligations, any factored receivables, as well as derivatives which are not used for hedging purposes. The debt is easy to find once you've become familiar with the various terminology. Derivatives, which can also appear as assets, should be examined. Any that are not hedging related should be counted as an obligation. Other non-current items, which are often on balance sheets, are typically related to employee benefits and pension related benefits, and those should be examined in the notes. One note is that operating leases, which were once a necessary off-balance sheet adjustment, will now be included as debt related obligations on the balance sheet going forward as a result of FASB ASC 842 in the US and IFRS 16.

In this note for derivatives, the derivatives that do not qualify for hedging would be considered debt-like obligations. Upon examining the notes, we see there's a very small balance of non-hedge liabilities, so most likely we would ignore this. In the next note, for other non-current liabilities, the other payables amount appear to be obligations, but not pension related. So we would most likely ignore this as well. Pension adjustments are handled differently by the different rating agencies, and there perhaps will be a different methodology inside your own financial institution. Moody's methodology, shown here, is the more complicated of the two major rating agencies. We have chosen to use the S&P version in our examples, as it is much more straightforward. They are similar in their net effect. Using either Moody's or S&P, or the internal methodology of your own financial institution should hopefully not create meaningful differences. We will do a workout on pension related benefits, both after this section, and after the section on earnings as well. Once we have a firm grasp of the obligations on the balance sheet, we can begin the ratio analysis. Debt to equity ratio is a leverage ratio of debt funding to current owner funding. It gives a sense of the ownership contribution to the balance sheet. Debt to capital is another version of this that looks at debt as a percentage of total funding. It is a variation on the debt to equity, and it is a little bit more intuitive as it expresses debt as a percentage of the capital structure. Debt to total assets reveals the leverage relative to the asset base. This can be adjusted to include only tangible assets, or fixed assets, or fixed assets plus intangible assets, excluding goodwill. It reveals how conservatively or aggressively a company finances its assets. All of the ratios can be modified, and most ratios are defined in-house. Debt can both include the off-balance sheet items or not. We can also use net debt, which is total debt minus any cash and marketable securities. The equity value can be either the book value or the market value of the equity.