RISK ANALYSIS

RISK ANALYSIS
 Risk Analysis examines the uncertainty of
income flows for the total firm and for the
individual sources of capital (that is, debt,
preferred stock, and common stock). The
typical approach examines the major
factors that cause a firm’s income flows
to vary. More volatile income flows mean
greater risk (uncertainty) facing
behaviour.
BUSINESS RISK
 Business risk is the exposure a company or organization has to factor(s) that will lower its
profits or lead it to fail. Anything that threatens a company's ability to achieve its financial
goals is considered a business risk. There are many factors that can converge to create business
risk. Sometimes it is a company's top leadership or management that creates situations where a
business may be exposed to a greater degree of risk.
 However, sometimes the cause of risk is external to a company. Because of this, it is
impossible for a company to completely shelter itself from risk. However, there are ways to
mitigate the overall risks associated with operating a business; most companies accomplish
this through adopting a risk management strategy.
 A company with a higher amount of business risk may decide to adopt a capital structure with
a lower debt ratio to ensure that it can meet its financial obligations at all times. With a low
debt ratio, when revenues drop the company may not be able to service its debt (and this may
lead to bankruptcy). On the other hand, when revenues increase, a company with a low debt
ratio experiences larger profits and is able to keep up with its obligations.
UNDERSTANDING BUSINESS
RISK
 When a company experiences a high degree of business risk, it may impair its ability to
provide investors and stakeholders with adequate returns. For example, the CEO of a company
may make certain decisions that affect its profits, or the CEO may not accurately anticipate
certain events in the future, causing the business to incur losses or fail.
 Business risk is influenced by a number of different factors including:
 Consumer preferences, demand, and sales volumes
 Per-unit price and input costs
 Competition
 The overall economic climate
 Government regulations
TYPES OF BUSINESS RISK
 STRATEGIC RISK
 Strategic risk arises when a business does not operate according to its business model or plan. When a
company does not operate according to its business model, its strategy becomes less effective over time and
it may struggle to reach its defined goals. If, for example, Walmart strategically positions itself as a low-
cost provider and Target decides to undercut Walmart's prices, this becomes a strategic risk for Walmart.
 COMPLIANCE RISK
 The second form of business risk is referred to as compliance risk. Compliance risk primarily arises in
industries and sectors that are highly regulated. For example, in the wine industry, there is a three-tier
system of distribution that requires wholesalers in the U.S. to sell wine to a retailer (who then sells it to
consumers). This system prohibits wineries from selling their products directly to retail stores in some
states.
 However, there are many U.S. states that do not have this type of distribution system; compliance risk
arises when a brand fails to understand the individual requirements of the state that it is operating within. In
this situation, a brand risks becoming non-compliant with state-specific distribution laws.
TYPES OF BUSINESS RISK
 OPERATIONAL RISK
 The third type of business risk is operational risk. This risk arises from within the corporation,
especially when the day-to-day operations of a company fail to perform. For example, in 2012,
the multinational bank HSBC faced a high degree of operational risk and as a result, incurred a
large fine from the U.S. Department of Justice when its internal anti-money laundering
operations team was unable to adequately stop money laundering in Mexico.1
 REPUTATIONAL RISK
 Any time a company's reputation is ruined, either by an event that was the result of a previous
business risk or by a different occurrence, it runs the risk of losing customers and its brand
loyalty suffering. The reputation of HSBC faltered in the aftermath of the fine it was levied for
poor anti-money laundering practices.
TYPES OF BUSINESS RISK
 Special Considerations
 Business risk cannot be entirely avoided because it is unpredictable. However, there are many strategies that
businesses employ to cut back the impact of all types of business risk, including strategic, compliance, operational,
and reputational risk.
 The first step that brands typically take is to identify all sources of risk in their business plan. These aren't just
external risks—they may also come from within the business itself. Taking action to cut back the risks as soon as
they present themselves is key. Management should come up with a plan in order to deal with any identifiable risks
before they become too great.
 Once the management of a company has come up with a plan to deal with the risk, it's important that they take the
extra step of documenting everything in case the same situation arises again. After all, business risk isn't static—it
tends to repeat itself during the business cycle.
 Finally, most companies adopt a risk management strategy. This can be done either before the business begins
operations or after it experiences a setback. Ideally, a risk management strategy will help the company be better
prepared to deal with risks as they present themselves. The plan should have tested ideas and procedures in place in
the event that risk presents itself
FINANCIAL RISK?

 Financial risk is the possibility of losing money on an investment or business venture. Some
more common and distinct financial risks include credit risk, liquidity risk, and operational
risk.
 Financial risk is a type of danger that can result in the loss of capital to interested parties. For
governments, this can mean they are unable to control monetary policy and default on bonds
or other debt issues. Corporations also face the possibility of default on debt they undertake
but may also experience failure in an undertaking the causes a financial burden on the
business.
UNDERSTANDING FINANCIAL
RISKS FOR BUSINESSES
 Financial markets face financial risk due to various macroeconomic forces, changes to the
market interest rate, and the possibility of default by sectors or large corporations. Individuals
face financial risk when they make decisions that may jeopardize their income or ability to pay
a debt they have assumed.
 Financial risks are everywhere and come in many shapes and sizes, affecting nearly everyone.
You should be aware of the presence of financial risks. Knowing the dangers and how to
protect yourself will not eliminate the risk, but it can mitigate their harm and reduce the
chances of a negative outcome.
 It is expensive to build a business from the ground up. At some point in any company's life the
business may need to seek outside capital to grow. This need for funding creates a financial
risk to both the business and to any investors or stakeholders invested in the company.
 Credit risk—also known as default risk—is the danger associated with borrowing money.
Should the borrower become unable to repay the loan, they will default. Investors affected by
credit risk suffer from decreased income from loan repayments, as well as lost principal and
interest. Creditors may also experience a rise in costs for the collection of debt.
 When only one or a handful of companies are struggling it is known as a specific risk. This
danger, related to a company or small group of companies, includes issues related to capital
structure, financial transactions, and exposure to default. The term is typically used to reflect
an investor's uncertainty about collecting returns and the accompanying potential for monetary
loss.
 Businesses can experience operational risk when they have poor management or flawed
financial reasoning. Based on internal factors, this is the risk of failing to succeed in its
undertakings.
HOW GOVERNMENTS
OFFSET FINANCIAL RISK
 Financial risk also refers to the possibility of a government losing control of its monetary
policy and being unable or unwilling to control inflation and 
defaulting on its bonds or other debt issues.
 Governments issue debt in the form of bonds and notes to fund wars, build bridges and other
infrastructure and pay for their general day-to-day operations. The U.S. government's debt—
known as Treasury bonds—is considered one of the safest investments in the world.
 The list of governments that have defaulted on debt they issued includes Russia, Argentina,
Greece, and Venezuela. Sometimes these entities only delay debt payments or pay less than the
agreed-upon amount; either way, it causes financial risk to investors and other stakeholders.
THE IMPACT OF FINANCIAL
RISKS ON MARKETS
 Several types of financial risk are tied to financial markets. As mentioned earlier, many
circumstances can impact the financial market. As demonstrated during the 2007 to 2008
global financial crisis, when a critical sector of the market struggles it can impact the monetary
wellbeing of the entire marketplace. During this time, businesses closed, investors lost
fortunes, and governments were forced to rethink their monetary policy. However, many other
events also impact the market.
 Volatility brings uncertainty about the fair value of market assets. Seen as a statistical measure,
volatility reflects the confidence of the stakeholders that market returns match the actual
valuation of individual assets and the marketplace as a whole. Measured as implied volatility
 (IV) and represented by a percentage, this statistical value indicates the bullish or bearish—
market on the rise versus the market in decline—view of investments. Volatility or equity risk
can cause abrupt price swings in shares of stock. 
THE IMPACT OF FINANCIAL
RISKS ON MARKETS
 Default and changes in the market interest rate can also pose a financial risk. Defaults happen
mainly in the debt or bond market as companies or other issuers fail to pay their debt
obligations, harming investors. Changes in the market interest rate can push individual
securities into being unprofitable for investors, forcing them into lower-paying debt securities
or facing negative returns.
 Asset-backed risk is the chance that asset-backed securities—pools of various types of loans—
may become volatile if the underlying securities also change in value. Sub-categories of asset-
backed risk involve the borrower paying off a debt early, thus ending the income stream from
repayments and significant changes in interest rates.
HOW FINANCIAL RISKS
IMPACT INDIVIDUALS
 Individuals can face financial risk when they make poor decisions. This hazard can have wide-ranging causes from
taking an unnecessary day off of work to investing in highly speculative investments. Every undertaking has exposure
to pure risk—dangers that cannot be controlled, but some are done without fully realizing the consequences.
 LIQUIDITY RISK comes in two flavors for investors to fear. The first involves securities and assets that cannot be
purchased or sold quickly enough to cut losses in a volatile market. Known as market liquidity risk this is a situation
where there are few buyers but many sellers. The second risk is funding or cash flow liquidity risk. Funding liquidity
risk is the possibility that a corporation will not have the capital to pay its debt, forcing it to default, and harming
stakeholders.
 SPECULATIVE RISK is one where a profit or gain has an uncertain chance of success. Perhaps the investor did not
conduct proper research before investing, reached too far for gains, or invested too large of a portion of their net worth
into a single investment.
 Investors holding foreign currencies are exposed to currency risk because different factors, such as interest rate changes
and monetary policy changes, can alter the calculated worth or the value of their money. Meanwhile, changes in prices
because of market differences, political changes, natural calamities, diplomatic changes, or economic conflicts may
cause volatile foreign investment conditions that may expose businesses and individuals to foreign investment risk.
PROS AND CONS OF
FINANCIAL RISK
 Financial risk, in itself, is not inherently good or bad but only exists to different degrees. Of
course, "risk" by its very nature has a negative connotation, and financial risk is no exception.
A risk can spread from one business to affect an entire sector, market, or even the world. Risk
can stem from uncontrollable outside sources or forces, and it is often difficult to overcome.
 While it isn't exactly a positive attribute, understanding the possibility of financial risk can
lead to better, more informed business or investment decisions. Assessing the degree of
financial risk associated with a security or asset helps determine or set that investment's value.
Risk is the flip side of the reward.
 One could argue that no progress or growth can occur, be it in a business or a portfolio, without assuming
some risk. Finally, while financial risk usually cannot be controlled, exposure to it can be limited or managed.
 Financial Risk

PROS
 Encourages more informed decisions
 Helps assess value (risk-reward ratio)
 Can be identified using analysis tools

CONS
 Can arise from uncontrollable or unpredictable outside forces
 Risks can be difficult to overcome
 Ability to spread and affect entire sectors or markets
TOOLS TO CONTROL
FINANCIAL RISK
 Luckily there are many tools available to individuals, businesses, and governments that allow
them to calculate the amount of financial risk they are taking on.
 The most common methods that investment professionals use to analyze risks associated with
long-term investments—or the stock market as a whole—include:
 Fundamental analysis, the process of measuring a security's intrinsic value by evaluating all
aspects of the underlying business including the firm's assets and its earnings.
 Technical analysis, the process of evaluating securities through statistics and looking at
historical returns, trade volume, share prices, and other performance data.
 Quantitative analysis, the evaluation of the historical performance of a company using specific
financial ratio calculations.
 For example, when evaluating businesses, the debt-to-capital ratio measures the proportion of
debt used given the total capital structure of the company. A high proportion of debt indicates
a risky investment. Another ratio, the capital expenditure ratio, divides cash flow from
operations by capital expenditures to see how much money a company will have left to keep
the business running after it services its debt.
 In terms of action, professional money managers, traders, individual investors, and corporate
investment officers use hedging techniques to reduce their exposure to various risks. Hedging
against investment risk means strategically using instruments—such as options contracts—to
offset the chance of any adverse price movements. In other words, you hedge one investment
by making another.
REAL-WORLD EXAMPLE OF
FINANCIAL RISK
 Bloomberg and other financial commentators point to the June 2018 closure of retailer Toys
"R" Us as proof of the immense financial risk associated with debt-heavy buyouts and capital
structures, which inherently heighten the risk for creditors and investors.
 In September 2017, Toys "R'" Us announced it had voluntarily filed for bankruptcy. In a
statement released alongside the announcement, the company's chair and CEO said the
company was working with debtholders and other creditors to restructure the $5 billion of
long-term debt on its balance sheet.
 As reported in an article by CNN Money, much of this financial risk reportedly stemmed from
a 2005 US $6.6 billion leveraged buyout (LBO) of Toys "R" Us by mammoth investment
firms Bain Capital, KKR & Co., and Vornado Realty Trust.4 The purchase, which took the
company private, left it with $5.3 billion in debt secured by its assets and it never really
recovered, saddled as it was by $400 million worth of interest payments annually.
REAL-WORLD EXAMPLE OF
FINANCIAL RISK
 The Morgan-led syndicate commitment didn't work. In March 2018, after a disappointing holiday
season, Toys "R" Us announced that it would be liquidating all of its 735 U.S. locations to offset
the strain of dwindling revenue and cash amid looming financial obligations.6 Reports at the time
also noted that Toys "R" Us was having difficulty selling many of the properties, an example
of the liquidity risk that can be associated with real estate.
 In November 2018, the hedge funds and Toys "R" Us' debt holders Solus Alternative Asset
Management and Angelo Gordon took control of the bankrupt company and talked about reviving
the chain. In February 2019, The Associated Press reported that a new company staffed with ex-
Toys "R" Us execs, Tru Kids Brands, would relaunch the brand with new stores later in the year.
 In late 2019, Tru Kids Brands opened two new stores—one in Paramus, New Jersey, and the
other in Houston, Texas.8 Most recently, Macy's has partnered with WHP Global to bring back
the Toys "R" Us brand. In 2022, Macy's plans to roll out approximately 400 physical toy store
storefronts within existing Macy's locations.
HOW DO YOU IDENTIFY
FINANCIAL RISKS?
 Identifying financial risks involves considering the risk factors a company faces. This entails
reviewing corporate balance sheets and statements of financial positions, understanding
weaknesses within the company's operating plan, and comparing metrics to other companies
within the same industry. There are several statistical analysis techniques used to identify the
risk areas of a company.
HOW DO YOU HANDLE
FINANCIAL RISK?
 Financial risk can often be mitigated, although it may be difficult or unnecessarily expensive
for some to completely eliminate the risk. Financial risk can be neutralized by holding the
right amount of insurance, diversifying your investments, holding sufficient funds for
emergencies, and maintaining different income streams.
WHY IS FINANCIAL RISK
IMPORTANT?
 Understanding, measuring, and mitigating financial risk is critical for the long-term success of
an organization. Financial risk may prevent a company from successfully accomplishing its
finance-related objectives like paying loans on time, carrying a healthy amount of debt, or
delivering goods on time. By understanding what causes financial risk and putting measures in
place to prevent it, a company will likely experience stronger operating performance and yield
better returns.
THE BOTTOM LINE
 Financial risk naturally occurs across businesses, markets, governments, and individual
finance. These entities trade the opportunity to make profits and yield gains for the chance that
they may lose money or face detrimental circumstances. These entities can use fundamental,
technical, and quantitative analysis to not only forecast risk but make plans to reduce or
mitigate it.
LIQUIDITY RISK
 Liquidity risk is the risk that a company or individual will not have enough cash to meet its
financial obligations (pay its debts) on time. Liquidity refers to the ease at which an asset can
be converted into cash without negatively affecting its market price; the risk arises when a
company cannot buy or sell an investment in exchange for cash fast enough to pay its debts.
UNDERSTANDING
LIQUIDITY RISK
 Common knowledge is that the smaller the size of the security or its issuer, the larger the
liquidity risk. Drops in the value of stocks and other securities motivated many investors to
sell their holdings at any price in the aftermath of the 9/11 attacks, as well as during the 2007
to 2008 global credit crisis. This rush to the exits caused widening bid-ask spreads and large
price declines, which further contributed to market illiquidity.
 Liquidity risk occurs when an individual investor, business, or financial institution cannot
meet its short-term debt obligations. The investor or entity might be unable to convert an asset
 into cash without giving up capital and income due to a lack of buyers or an inefficient market
.
LIQUIDITY RISK IN
FINANCIAL INSTITUTIONS
 Financial institutions depend upon borrowed money to a considerable extent, so they're
commonly scrutinized to determine whether they can meet their debt obligations without
realizing great losses, which could be catastrophic. Institutions, therefore, face
strict compliance requirements and stress tests to measure their financial stability.
 The Federal Deposit Insurance Corporation (FDIC) released a proposal in April 2016 that
created a net stable funding ratio. It was intended to help increase banks’ liquidity during
periods of financial stress. The ratio indicates whether banks own enough high-quality assets
that can be easily converted into cash within one year. Banks rely less on short-term funding,
which tends to be more volatile.
 During the 2008 financial crisis, many big banks failed or faced insolvency issues due to
liquidity problems. The FDIC ratio is in line with the international Basel standard, created in
2015, and it reduces banks’ vulnerability in the event of another financial crisis.
LIQUIDITY RISK IN
COMPANIES
 Investors, managers, and creditors use liquidity measurement ratios when deciding the level of
risk within an organization. They often compare short-term liabilities and the liquid assets
listed on a company’s financial statements.
 If a business has too much liquidity risk, it must sell its assets, bring in additional revenue, or
find another way to reduce the discrepancy between available cash and its debt obligations.
EXAMPLE OF LIQUIDITY
RISK
 A $500,000 home might have no buyer when the real estate market is down, but the home
might sell above its listed price when the market improves. The owners might sell the home
for less and lose money in the transaction if they need cash quickly so must sell while the
market is down.
 Investors should consider whether they can convert their short-term debt obligations into cash
before investing in long-term illiquid assets to hedge against liquidity risk.