Risk, as an inherent of doing business, should be paid enough attention by investors before making investment decisions. As it is known to all, there are many uncertain factors in operating activities such as economy condition, unemployed rate, inflation rate, and disposable income and so on (Cnexr, 2004). The change of these factors may bring risk to the companies like management risk, operating risk, marketing risk, etc. At the same time, it will bring financial risk to the companies. In this essay, it will mainly draw a discussion about how and when risk arises in finance and how this can be evaluated with the explanations of real-life examples.
2.0 Discuss and analysis
2.1 Profitability risk
It is known to all, the aim of capital is to pursuit benefits. According to the structure of income statement, profit can be calculated by the following formulation:
Profit = sales revenue - cost of sales - period expenses - taxation
As a result, the profitability risk arises when there is an increase of cost, period expenses or taxation. For example, the cost of product often concludes direct material, direct labor, manufacture cost. If there is inflation, the price of material will increase probably. Thus, the gross profit margin of product will be increased (Tarhan, 2003). For accountants, the financial reports must be provided monthly at the end of accounting period. Therefore, the profitability risk can be detected from the financial reports. In order to evaluate this index, there are many financial indicators in financial performance management such as return on capital employed (ROCE), gross profit margin, net profit margin and so on (Glen, 2001). Generally speaking, the higher of these indicators, the better profitability of the company will be. For example, Croda, a listed company in UK. The profitability of this company is in the decreasing trend from 2008 to 2010. In 2008, the net profit margin is 11.37%, and this indicator is decreased to 8.76% in 2010. But the sales revenue is increased from £ 804.8 million to £ 916.2 million (Fama & French, 2005). The profit is decreased with the increase of sales revenue. Why? After analysis in the financial reports for the three years, the increase of sales expenses is the key factor of this performance. The sales expenses are only £ 37 million in 2008, which is increased to £ 147 million in 2010 in order to implement new promotion strategy (Fama & French, 2005). As a result, the decrease trend of profitability is provided by the financial reports.
Although there is a decrease trend of profitability for Croda from 2008 to 2010, the operating performance will be expected to improve in the future. Because the positive promotion strategy is helpful for brand promotion and getting potential market shares, the company will achieve benefits in economy scale.
2.2 Debt paying risk
Another finance risk is liquidity risk in operating activities. As it is known to all, there must be enough current assets to repay debts timely for companies. Otherwise, the companies may have the liquidity risk. If this financial condition goes on, there may be a bankruptcy risk for the companies. Therefore, it can be concluded liquidity risk may arise when there is not enough current assets to repay debts. In order to evaluate this index, there are many financial indicators like current ratio, acid test ratio, etc (Glen, 2001). Generally speaking, if the indicator of current ratio is above 2 times or the acid test ratio is over 1 time of a company, the liquidity risk is thought to be low. For example, Tesco, as a world famous supermarket, has developed rapidly over the past decade by implementing its well established and consistent strategy. Currently, it comes over the liquidity problems due to the excessive business expansion. The current ratio in 2010 is 0.71 times, which is decreased by 0.03 times comparing to 0.74 times in 2009. And the acid test ratio is also decreased by 0.05 times from 0.59 times to 0.54 times (Raviv, 1991). According to the experience data, the liquidity of Tesco is too low to repay debts timely. As a result, there will be a liquidity risk if the current condition goes on.
Although there is liquidity risk for Tesco, it can be said the high efficiency management of current assets from another angle. Because the less current assets in the financial reports, the higher assets turnover of the company will be. That means the higher efficiency of assets management. As a result, the company will achieve more benefits with certain amounts of assets.
2.3 Leverage risk
With the development of economy and capital market, the invested capital does not adapt the enlarged business scale. In order to solve the capital bottleneck to achieve potential operating successes, more and more companies are financing from different organizations and investors such as banks, individual investors, etc. The more you financed the higher leverage risk you will meet because there is cost of capital (Jean, 2006). As it is known to all, capital suppliers achieve interest benefits by lending capital to debtors. Thus, there is a pressure for the debtors to repay interest periodic and initial capital. If the operating activities are not performed as expected, the debtors probably do not have the ability to repay interest and capital timely because the uncertain factors in market. At this time, leverage risk arises. There are two mainly financial indicators to evaluate this index. They are gearing ratio and interest cover ratio (Glen, 2001). The higher of gearing ratio the higher finance risk of the company will be. But the finance risk of the company will be lower with the increase tend of interest cover ratio. Investors or creditors can achieve the repayment ability of the company from these two financial indicators. For example, the gearing ratio of Jours Plc in 2007 is 47.15%. In 2008, the indicator is increased to 62.06%. Higher gearing ratio means the big proportion of the company's money is borrowed and the risk is bigger. If the interest rate rises, more interest should be paid with no corresponding increase in sales revenue. The company will suffer a tough situation. And the interest cover ratio is increased to 12.39 times from 5.78 times (Martin & Petty, 2005). It means that the level of operating profit is considerably higher than that of interest payable. Therefore, there is no risk in paying interest.
Although there may be gearing risk with the increase of debts, the company may achieve leverage by financing because the margin between benefits and interests.
3.0 Conclusion
Based on the analysis, finance risk is full of operating activities. Every change in operating or finance activities may bring risk to the company. Every thing has two sides, so does finance risk. The company may achieve benefits by bearing high risk such as leverage, increased market shares and so on. Thus, as the deciders of the company, they should have a clear idea about the advantages and disadvantages of making each operating decisions.
