Risk Management in Financial Management Process of a Company

What is risk?

Risk refers to the volatility of returns in both positive and negative side that can be quantified through statistical measures such as probabilities, standard deviations and correlations between different returns.

The volatility of returns of a project or an asset should be managed if it results in increasing the value of the company. A risk management strategy that increases the return from the project or asset at a lower comparative cost towards risk management would benefit the company and its shareholders.

Business Risk

The business risk refers to the company’s ability to generate sufficient revenue to cover its operational expenses; which arises from the type of business and related uncertainties.

The asset beta otherwise known as unlevered beta or ungeared beta is the beta of the company without the impact of debt, which reflects the business risk in the company’s business operations.

Financial Risk

The financial risk refers to the risks relating to the financial structure, gearing level, and the risk affecting the return to shareholders of the company.

The equity beta known as levered beta or geared beta is the beta of the company with the impact of debt which reflects both the business and financial risk in the company’s overall operation. The equity beta is usually higher than the company’s asset beta because it includes the gearing impact reflecting the financial risk of the company.

Return and cost of equity

The return required by investors is the sum of the risk-free rate (Rf) and a premium for the risk (Rm-Rf) multiplied by equity beta (levered beta). Assuming investors hold well-diversified portfolios of investments then they are only exposed to systematic risk (market risk) as their exposure to firm-specific risk (unsystematic risk) has been diversified away.

Usually companies with diverse equity holdings do not increase value by diversifying company specific risk, as their equity holders have already achieved this level of risk diversification.

Risk Management Activity for Systematic Risk

The risk management activity designed to transfer systematic risk (market risk) would not provide additional benefits to a company because, in perfect markets, the benefits achieved from risk management activity would at least equal the costs of undertaking such activity. Therefore, in a situation of perfect markets, it may be argued that risk management activity may not be beneficial to the company and its shareholders because costs of risk management would either equal or be more than the benefits accrued.

Market imperfections that exist in the real world, as opposed to the perfect world conditions assumed by finance or economic theory. These market imperfections may provide opportunities to reduce volatility in cash flows and thereby reduce the costs in a company. Market imperfections resulting such opportunities may be as follows:

• Taxation: The taxation slabs and schedules are progressive based on company’s profit level. Risk management activity may be created to support in reducing the tax expenses of a company by reducing the volatility of the earnings.
• Insolvency and financial distress: In a situation of financial insolvency or financial distress, there would be additional cost both direct and indirect, for example in a situation of financial distress where a company operates on a day-to-day basis, there may be additional warranty demand from customers, unfavorable credit terms by supplier, and higher cost of borrowing etc. If a company actively manages its risk and prevents or reduces the possibility of financial distress, it will find it easier to contract with its stakeholders at a lower cost. Therefore, the more volatile the cash flows of a company, the more likely the need to manage its risk in order to reduce the costs related to financial distress.
• External funding and agency cost: In some situations, a financial distress may make the cost of external debt and equity funding so expensive that a company’s management may be forced reject profitable projects. If the management of company tries to raise equity finance for relatively less risky projects, then the profits earned from such projects would initially go to the debt holders and the equity holders will gain only residual profits. Therefore, shareholders would put pressure on the management of the company to reject good, low risk projects, which may have been acceptable to the debt providers. The risk management in reducing financial distress by reducing the volatility of the company’s cash inflows may help the management to obtain an optimal mix of debt and equity, and to undertake profitable projects in the interest of value creation for company.
• Capital structure and information availability: Risk management stabilizes the cash flows that companies receives from year to year, then this would enable the management to plan when the necessary internal funds will become available for future investments with greater accuracy. The managers will then be able to align their investment policies with the availability of funding. The pecking order theory in financial management process provides that the cost of financing increases with asymmetric information. The hierarchical order of financing comes from: (1) internal funds like general reserves or retained earnings, (2) debt borrowings, and (3) new equity shares issue. It has been observed that directors and mangers would prefer to use internally generated funds rather than going to external markets because it is cheaper. Hence, risk management is essential which stabilizes the variability of cash inflows.
• Management’s behaviour towards risk management: The directors and managers in a company, whose performance reward structure includes large equity stakes in a company, are more likely to reduce the risk, as opposed to managers whose performance reward structure is based primarily on equity options. Directors or Managers who hold concentrated equity stakes in a company face increased levels of risk when compared to other equity holders. The investors hold well-diversified portfolios and face exposure to systematic risk or market risk only. But managers with concentrated equity stakes would face both systematic and unsystematic risk. Therefore, they have a greater propensity to reduce the unsystematic risk or company specific risk. A concentrated equity positions occur when a significant portion of an investor’s wealth is tied to the stock of a single company.
• Testing the impact of risk management: A company manages their risks in the belief that this would create or increase company’s value, however in many situation a direct link between risk management and corresponding value creation is very difficult to establish.