ASSIGNMENT # 1

On
Business Risk & Financial Risk
Submitted To:
Prof. Ayyub Arshad
Submitted By:
Syed Fahad Siraj
Subject:
Corporate Financial Strategy
Registration No:
M1F13MBAM0020
Program:
MBA (6th Semester)

UNIVERSITY OF CENTRAL PUNJAB

Q1: Briefly describe that how business risk and financial risk are
correlated with each other.
Financial risk refers to a company's ability to manage its debt and financial leverage, while
business risk refers to the company's ability to generate sufficient revenue to cover its
operational expenses. An alternate way of viewing the difference is to see financial risk as the
risk that a company may default on its debt payments, and business risk as the risk that the
company will be unable to function as a profitable enterprise.
Financial Risk:
A company's financial risk is related to the company's use of financial leverage and debt
financing, rather than the operational risk of making the company a profitable enterprise.
Financial risk is concerned with a company's ability to generate sufficient cash flow to be
able to make interest payments on financing or meet other debt-related obligations.
Obviously, a company with a relatively higher level of debt financing carries a higher level of
financial risk, since there is a greater possibility of the company not being able to meet its
financial obligations and becoming insolvent.
Some of the factors that may affect a company's financial risk are interest rate changes and
the overall percentage of its debt financing. Companies with greater amounts of equity
financing are in a better position to handle their debt burden. One of the primary financial
risk ratios that analysts and investors consider to determine a company's financial soundness
is the debt/equity ratio, which measures the relative percentage of debt and equity financing.

Business Risk:
Business risk refers to the basic viability of a business, the question of whether a company
will be able to make sufficient sales and generate sufficient revenues to cover its operational
expenses and turn a profit. While financial risk is concerned with the costs of financing,
business risk is concerned with all the other expenses a business must cover to remain
operational and functioning. These expenses include salaries, production costs, facility rent,
and office and administrative expenses.
The level of a company's business risk is influenced by factors such as its cost of goods,
profit margins, competition, and the overall level of demand for the products or services that
it sells.
Business risk is often categorized into systematic risk and unsystematic risk.

Systematic risk refers to the general level of risk associated with any business enterprise,
the basic risk resulting from fluctuating economic, political and market conditions.
Systematic risk is an inherent business risk that companies usually have little control
over, other than their ability to anticipate and react to changing conditions.
Unsystematic risk, however, refers to the risks related to the specific business in which a
company is engaged. A company can reduce its level of unsystematic risk through good
management decisions regarding costs, expenses, investments and marketing. Operating
leverage and free cash flow are metrics that investors use to assess a company's
operational efficiency and management of financial resources.

Difference between business and financial risks:

What are business and financial risks?
Business Risk: Business risk is the small or large risks involved in the operations of
the company.
Financial Risk: Financial risk is related to the structuring of the finances of an
organization.
Are these risks independent of the debt that the business owes?
Business Risk: Yes
Financial Risk: No
What does the variability of these risks imply?
Business Risk: It implies the uncertainty of operating income or Earnings before
Interest and Taxes (EBIT).
Financial Risk: It implies the uncertainty of earnings per share and the risk of
insolvency due to utilization of funds from the fixed-cost sources.
Where are these risks reflected?
Business Risk: It is reflected in the variability of net operating income or net cash
flows.
Financial Risk: It is reflected in the variability of net cash flows of the equity owners.
How are these risks calculated?
Business Risk: It can be calculated by, dividing net income by total income, or returns
to investors by total assets.
Financial Risk: It can be calculated using contribution margin, operating leverage
effect, financial leverage effect, and total leverage effect ratios.
How to minimize these risks?
Business Risk: It can be minimized by incorporating right strategies to combat the
internal and external factors which contribute to the risk.
Financial Risk: It can be minimized by maintaining an adequate cash flow, taking
strategic financial decisions and undertaking hedging using financial instruments.
What are the different types of business and financial risks?
Business Risk: Strategic risk, reputational risk, operational risks, compliance risk, etc.
Financial Risk: Credit risk, market risk, liquidity risk and interest rate risk.
Can these risks be controlled completely?
Business Risk: No, it cannot be controlled completely as it is inherent in the
operations of the business.
Financial Risk: Yes, it can be controlled completely by limiting the amount raised
through debts.
What are the factors contributing to these risks?

Business Risk: The variability in demand for its products, variability in the input cost,
operating leverage, variability of sales price, etc. are the pivotal factors which increase
the business risk of an organization. Entering into an entirely new business, buying
stake in a company, reducing the stake in a company, introducing new products in the
market, etc. are the important aspects that are related to the business risk. It is also
associated with the issues regarding returns on assets of the company.
Financial Risk: Any increase in the interest rates can affect your cash flows. The ever
changing foreign exchange rates also add to the financial risk of a company. Financial
risks in the international business are much more than those involved in domestic
business. A lack of study of international markets can significantly increase the
financial risk. Also, it increases when a certain organization decides to use debt from
financial institutions for business expansion along with equity financing.

Q2: How business risks are associated with cash flow over product life
cycle?
The 'product life cycle' is split into 5 stages:
o
o
o
o
o

Research and development

Introduction
Growth
Maturity/Saturation
Decline

The Product Life Cycle:

Product is one part of the marketing mix. For marketing to be effective a business must be
aware of its PRODUCT LIFE CYCLE. The product life cycle shows the different stages that
a product passes through over time and the sales that can be expected at each stage. By
considering product life cycles businesses can plan for the future. Most products pass through
six stages - development, introduction, growth, maturity, saturation and decline.

Development: During the development stage the product is being researched and designed.
Suitable ideas must be investigated, developed and tested. If an idea is considered worth
pursuing then a prototype or model of the product might be produced. A decision will then be
made about whether or not to launch the product. A large number of new products never
progress beyond this stage and will fail. This is because businesses are often reluctant to take
risks associated with new products. During the development stage it is likely that the business

will spend to develop the product and costs will be high. As there will be no sales at this
stage, the business will initially be spending but receiving no revenue.
Introduction: At the start of this stage the product will be launched. As the product is new to
the market. Sales initially are often slow. Costs are incurred when the product is launched. It
may be necessary to build a new production line or plant, and the firm will have to meet
promotion and distribution costs. A business is also likely to spend on promotion to make
consumers aware of the new product. Therefore, it is likely that the product will still not be
profitable. Prices may be set high to cover promotion costs. But they may also be set low in
order to break into the market. Few outlets may stock products at this stage. The length of
this stage will vary according to the product. With brand new technical products, e.g.
computers, the introduction stage can be quite long. It takes time for consumers to become
confident that such products work. At first the price 10 of such products may be quite high.
On the other hand, a product can be an instant hit resulting in very rapid sales growth.
Fashion products and some fast moving consumer goods may enjoy this type of start to their
life.
Growth: Once the product is established and consumers are aware of it, sales begin to grow
rapidly, new customers buy the product and there are repeat purchases. Costs may fall as
production increases. The product then becomes profitable. If it is a new product and there is
a rapid growth in sales, competitors may launch their own versions. This can lead to a
slowdown of the rise in sales. Businesses may need to consider their prices and promotion.
For example, a high price charged initially may need to be lowered, or promotion may need
to increase to encourage brand loyalty.
Maturity: At some stage the growth in sales will level off. The product has become
established with a stable market share at this point. Sales will have peaked and competitors
will have entered the market to take advantage of profits. As more firms enter the market, it
will become saturated. Some businesses will be forced out of the market, as there are too
many firms competing for consumers. During the maturity and saturation stages of the
product life cycle many businesses use extension strategies to extend the life of their
products.
Decline: For the majority of products, sales will eventually decline. This is usually due to
changing consumer tastes, new technology or the introduction of new products. The product
will lose its appeal to customers. At some stage it will be withdrawn or sold to another
business. It may still be possible to make a profit if a high price can be charged and little is
spent on promotion or other costs.

The product life cycle and cash flow

The cash flow of a business over a product life cycle.

Before product launch a business will spend to develop the product and yet no money

is coming into the business from sales. So cash flow is likely to be negative.
At launch, at point A, a product begins to sell. Cash flowing out of a business is still
likely to be greater than cash flowing in, so cash flow will be negative. Sales have yet

to take off and a business might be spending on promoting the product.

In the growth period, eventually revenue from the product will be greater than
spending (point B) and so cash flow becomes positive. This is because sales will be

increasing and average costs may be falling as output increases.

In the maturity stage cash flow will be at its highest. The product will be earning its

greatest revenue.
In the decline stage, sales will fall and so cash flow will decline.

The overall conclusion is that the relationship between the product life cycle and the cash
flow are very similar. When the product life cycle starts to grow so does the cash flow as it
does when the life cycle decreases. This is because if the product is selling more, than it is
obviously going to have a greater cash flow. If the product is selling less than the cash flow
will decrease with the product life cycle.