Risk and uncertainty have been part and parcel of human life from the very beginning. A simple definition of risk is something like expected pain, or the likelihood of an unfavourable outcome. It measures the uncertainty an investor is willing to take to realise a gain from an investment. In other words, it is the probability that the actual return on an investment will be lower than the expected return.
Measuring risk
As ‘risk’ affects how investors make decisions, measuring it is the critical first step towards managing it. Risk measurement examines the uncertainty of income flows for the company and for individual capital providers such as debt and equity shareholders. It involves examining the major factors that cause a firm’s income flows to vary. More volatile income flows mean greater risk (uncertainty) facing the investor. The total risk of a firm has two internal components: business risk and financial risk.
Forms
Business risk is the uncertainty of income caused by the industry to which the company belongs to. This uncertainty is due to the variance in the company’s sales caused by its products, customers and the way it produces its products. For example, the earnings for an iron and steel company will probably vary more than those for a grocery chain store because: (a) Over the business cycle, steel sales are more volatile than grocery sales; and (b) Steel companies have large fixed production costs that make earnings vary more than sales.
Business risk is generally measured by the variability of the firm’s operating income over time. In turn, earnings variability is measured by gauging standard deviation of historical operating earnings. The resulting ratio of the standard deviation of operating earnings is divided by average operating earnings.
Financial risk is the additional uncertainty of returns to shareholders due to a company’s use of fixed-obligation debt securities. This risk is in addition to a company’s business risk. When a company raises funds through debt capital, interest payments on this capital precede the computation of common stock earnings, and these interest payments are fixed contractual obligations.
Owing to the debt financing, during an economic expansion, the net earnings available for common stock after fixed interest payments will experience a larger percentage increase than operating earnings. In contrast, during a business decline, the earnings available to shareholders will decline by a larger percentage than operating earnings because of these fixed financial costs. Also, as a firm increases its relative debt financing with fixed contractual obligations, it increases its financial risk and the possibility of default and bankruptcy.
A very important point to remember is that the acceptable level of financial risk for a company depends on its business risk. If a company has low business risk, i.e., stable operating earnings, investors are willing to accept higher financial risk. For example, retail food companies typically have stable operating earnings over time and, therefore, relatively low business risk. As a result, investors and bond-rating agencies will allow a firm in this industry to have higher financial risk. This risk can be measured through debt-to-equity and debt-to-total capital ratios.
However, there are many other types of risks: inflationary/purchasing power risk, liquidity risk, market risk, social/political/legislative risk, interest rate risk, re-investment risk, currency/exchange rate risk, sovereign risk, payment system risk, settlement risk, etc. Though these are discussed in detail in investment science literature, business and financial risk are the most important from the investors’ decision-making point of view.
Risk cannot be separated from return. Every investment involves some degree of risk, which can be close to zero or very high, depending to the nature of the instrument in which the investment is made.
Risk can be quantifiable both in absolute and relative terms. A sound appreciation of the complexities of risk is an essential part of being a prudent investor. A thorough understanding of the concept of business and financial risk and their measurement can be very helpful to investors in better understanding the available opportunities and the trade-offs and costs involved with different investment avenues.
Covering Bases:
Business risk is generally measured by the variability of a firm’s operating income over time. In turn, earnings variability is measured by gauging the standard deviation of historical operating earnings
Specifically, a company’s operating earnings vary over time because its sales and production costs vary
Financial risk is the additional uncertainty of returns to shareholders due to a company’s use of fixed-obligation debt securities
The acceptable level of financial risk for a company depends on its business risk. If a company has low business risk, i.e., stable operating earnings, investors are willing to accept higher financial risk. This risk can be measured through debt-to-equity and debt-to-total capital ratios
The writer is associate professor of finance and accounting, IIM Shillong