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Business & Financial Risk




The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviations indicates a high degree of risk.

Business Risk
The possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. Or It is defined as the uncertainty inherent in projections of future returns, either on assets (ROA) or on equity (ROE), if the firm uses no debt or debt-like financing (i.e., preferred stock). Hence, it is the risk associated with the firms operations ignoring any fixed financing affects.

Financial Risk
It is defined as the additional risk over and above the basic business risk placed on common stockholders which results from using financing alternatives with fixed periodic payments, such as debt and preferred stock. Thus, it is the risk associated with the types of funds the firm uses to finance its assets.

Types of Business Risk

1. Financial Risk 2. Operational Risk 3. Other Risks

Financial Risk
Direct financial risks have to do with how your business handles money. That is, which customers do you extend credit to and for how long? What is your debt load? Does most of your income come from one or two clients who might not be able to pay? Financial risks also take into account interest rates and if you do international business, foreign exchange rates.

Operational Risk
Operational risks result from internal failures. That is, your businesss internal processes, people or systems fail unexpectedly. Therefore, unlike a strategic risk or a financial risk, there is no return on operational risks. Operational risks can also result from unforeseen external events such as transportation systems breaking down, or a supplier failing to deliver goods.

Other Risks
Other risks are more difficult to categorize. They include risks from the environment, such as natural disasters. Difficulties in maintaining a trained staff that has up-to-date skills to operate your business is sometimes called employee risk management. Health and safety risks not covered by OSHA or state agencies fall into this category as do political and economic instability in countries you import from or export to.

Types of Financial Risk

1. 2. 3. 4. Credit Risk Interest Rate Risk Market Risk Liquidity Risk

Credit Risk
The possibility that an investment will lose value owing to declining financial strength in the underlying company is referred to as credit risk. Default risk is one component, referring to the potential for a financially weakened company to default on its payments of interest and principal to bond holders and an eventual collapse of the enterprise, which makes the stock worthless. High credit risk, whether in terms of securities investments or consumer and corporate loans, leads to high interest rates to compensate for the potential of late payments or total default.

Interest Rate Risk

Risk that assets will yield a lower return or liabilities will be more expensive because of a change in interest rates. This risk applies only to interest-sensitive assets and interest-sensitive liabilities and directly affects the margin of interest and, hence, the annual reported earnings.

Market Risk
Market risk refers to the risk of loss sustained as a result of changes in the values of market prices/rates or factors that drive the value of financial instruments/ transactions.

Liquidity Risk
Liquidity risk refers to the risk of loss arising from the inability to trade instruments due to the absence of counterparties or the risk of loss arising from the inability to finance or invest cash, for example, the inability to re-finance obligations as and when they mature or the inability to refinance at anticipate rates.

Factors affecting Business Risk

Demand Variability: the more stable the demand for a firms products, other things held constant, the lower its business risk. Sales Price Variability: Firms whose products are sold in highly volatile markets are exposed to more business risk than similar firms whose output prices are more stable. Input Cost Variability: Firms whose input costs are highly uncertain are exposed to high degree of business risk. Ability to develop new products in timely cost-effective manner: Firms in such high-tech industries as drugs and computers depend on a constant stream of new products. The faster that products become obsolete, the greater the business risk.

Factors affecting Business Risk (continued)

Ability to adjust output prices for changes in input costs: Some firms are better able than others to raise their own output prices when input costs rise. The greater the ability to adjust output prices to reflect cost conditions, the lower the business risk. Foreign risk exposure: Firms that generate a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a politically unstable area, it may be subject to political risks. The extent to which costs are fixed: Operating leverage. If a high percentage of its costs are fixed, hence do not decline when demand falls, then the firm is exposed to relatively high degree of business risk. This factor is called operating leverage.

Factors affecting Financial Risk

Market Rates: Market rates are one of the most pervasive types of external factors when it comes to financial risk. The market changes based on consumer interest, supply and demand and new elements like technology. When the economy speeds up or slows down, interest rates for bonds and loans change. These changing rates can make it more expensive for a business to get a loan, or require it to make higher payments on bonds it uses to generate capital. Regulation: Government regulation is another important factor in all financial planning. Governments create tariffs (or taxes on imports and exports), changing existing tax laws and put new financial regulations into place constantly. Some changes are beneficial, such as creating tax deductions for certain business actions. Others can make it more difficult for a business to make a profit, such as lowering treasury bond rates and adding new requirements to tax reports.

Factors affecting Financial Risk (Continued)

Credit: Credit is halfway between being an external and internal factor. In many ways, business credit is an external factor of risk, because it depends on what outside lenders are willing to loan, and the rates or requirements lenders choose for the business. On the other hand, credit depends on the past decisions the business has made, what lenders it approaches and its current financial position -- internal factors. Liquidity: Liquidity is simply how easy it is for a business to turn securities into cash. Cash is the most liquid type of fund, but it also makes the least amount of money. Businesses must balance how much cash they hold for emergencies with less liquid securities like bonds or shares. Cash Flows: Cash flow refers to the daily revenues and expenses of the business. This is an internal factor of risk that depends on what expenses a business choose to pay and how much revenue is directed to specific areas of the business.

Risk Management:
Risk management is a scientific approach to dealing with pure risks by anticipating possible accidental losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur.

Risk Management Tools:

There are two broad techniques that are used in risk management for dealing with risks. 1. Risk Control 2. Risk Financing Risk Control: focuses on minimizing the risk of loss to which the firm is exposed. It has two other types, 1) Risk avoidance and 2) Risk reduction. Risk Financing: concentrates on arranging the availability of funds to meet losses arising from the risks that remain after the application of risk controlling techniques. It has two types, 1) Risk retention and 2) Risk Transfer

Types of Risk Control:

Risk Avoidance: Risk Avoidance takes place when decisions are made that prevent a risk from even coming into existence. Risks are avoided when the organization refuses to accept the risk, even for an instant. For example: A decision not to manufacture a particular dangerous product because of the inherent risk. Risk avoidance should be used in those instances in which the exposure has catastrophic potential and the risk can not be reduced or transferred.

Types of Risk Control: (Continued)

Risk Reduction: Risk reduction consists of all those techniques that are designed to reduce the likelihood of loss, or the potential severity of those losses that do occur. For example: we can prevent the occurrence of loss by prohibiting against smoking in areas where flammables are present. Decreasing the number of employee injuries by installing protective devices around machinery. Installation of cameras and sprinkler systems etc.

Types of Risk Financing:

Risk Retention: It is the most common method of dealing with risk. Individuals and organizations face an almost unlimited number of risks which can not be mitigated. It is a residual or default risk management technique. Any exposures that are not avoided, reduced, or transferred are retained. This means that when nothing is done about a particular exposure, the risk is retained.

Types of Risk Financing: (Continued)

Risk Transfer: A technique that involves the contractual shifting of a pure risk form one party to another. For example: The purchase of an insurance policy, by which the specified risk of loss is passed from the policyholder to the insurer. Another example of risk transfer is the process of hedging, in which an individual guards against the risk of price changes by buying or selling another asset whose price changes in an offsetting direction (e.g., Buying of derivatives, etc.)

Risk Management Plan:

Instructions: 1. Establish a risk management team 2. Perform a risk analysis on your business 3. Develop risk strategies (i.e., eliminate; share; mitigate; accept, etc.) 4. Implement risk controls

Risk Management Process

Determination of objectives Identification of risks Evaluation of risks Considering alternatives and selecting the risk treatment device Implementing the decision Evaluation and review