Everything You Need to Know About Risk Analysis in Financial Management

Concepts of Risk Analysis in Financial Management

Do you remember appearing for exams in school or college? There is one major concern you had. Am I fully prepared for the exam?

What can go wrong in an exam? In the worst-case scenario, the questions you prepared were not set by the examiner. There could also be questions set outside the syllabus!

Just like you were worried about these uncertainties, a company or an investor is worried about a different set of uncertainties. What are these uncertainties, and how do companies and investors deal with them? Let us find out, shall we? 

Companies operate in a very dynamic environment that is constantly changing. The major concerns for a company are adverse changes in Government policies, the Companies Act, or the national and international economy. These changes could result in lower profits or losses due to the success or failure of a project.

Investors also need to worry about the company’s performance or economic environment. Stock returns vary depending on the company’s performance and how it handles negative events like an increase in taxes or a fall in demand. 

The tool used by companies or investors to assess the risk in their external environment is called Risk Analysis. It helps companies navigate risks and minimize them. If you are interested in an exciting career in risk analysis, go for a course in risk management. 

A financial risk analyst will help boost the revenues of your organization in the following ways: 

• Risk Identification: All possible internal and external threats to your company are identified. Some threats that you could face include reputational risks, project risks, technical risks, market risks, and operational risks. To overcome these risks, you would require a SWOT (Strength, Weakness, Opportunity, Threat) analysis.

• Risk Estimation: What is the probability of occurrence of a particular risk in percentage terms? Risk Value = Probability x Cost. For example, if you feel that your landlord might increase the storage space rent by Rs. 5 lacs next year and the probability of this event is 80%, then the risk value is 5 lacs x 80% = Rs. Four lacs.

• Risk Management: Once you know the risk value, you can try to manage the risk. In the above example, you could either try to look for the most cost-effective storage facilities, improve revenues, or reduce costs in other areas. 

• Risk Avoidance: All opportunities are screened using a cost-benefit analysis, and if the benefits are greater than the costs, then the investment is worth it. If the costs are greater than the benefits, it is better to ignore such ventures. In the above example, if the cost of finding another storage space is too high, there is no point in looking for one. 

• Risk Sharing: You can try a new venture with a business partner to reduce risk or insure your assets through a third-party insurer to minimize losses.

• Risk Acceptance: When there is a possibility of a market crash and a general fall in demand, you need to accept the risk. You can extend higher credit to customers or offer higher discounts to control the revenue loss. 

You will learn all this and more in your risk management course. 

Examples of Risk Analysis in Financial Management

Let us understand risk analysis through a well-known Indian company, Tata Power. Here are some of the different risks faced by Tata Power and its strategy to mitigate these risks:

In the next section, we will try to understand risk analysis in more detail. 

Understanding Risk Analysis in Financial Management

You can estimate risk through a financial statement analysis. How do you analyze a financial statement, and how does it help to estimate risk? 

The key financial statements vital for risk analysis include the Cash Flow Statement, the Income Statement, and the Balance Sheet. While doing a risk management certification, you will understand how these financial statements help to identify and mitigate risk. 

Here is a brief description of the key financial statements:

Cash flow Statement: 

The difference between the revenues and expenses generated by a company determines its cash flow. The revenues are generated from three areas:

• Operating Activities – Revenues from operations are included under this heading
• Investing Activities – The income generated from investments is stated here
• Financing Activities – Income from equity and debt financing are included here

Income Statement

While doing a course in risk management, you need to know the details of the income and expenditure of a business. The income statement contains critical information like Gross Profit, Operating Profit, and Net Profit. The following table highlights the relationship between these three concepts: 

General Costs

XXX

XXX

Balance Sheet

The Balance Sheet helps you determine the value of a company. There are three components of a Balance Sheet. They are:

• Assets: The Fixed Assets (long-term) and Current Assets (short-term) come under this heading. Current assets include accounts receivable (debtors) of the company
• Current Liabilities: This includes accounts payable (creditors) of the company
• Shareholder’s Equity: The difference between Assets and Current Liabilities includes Shareholder’s Equity. A surplus of Income over Expenditure is added here every year. 

The Shareholder’s Equity is an important tool for measuring a company’s book value, and it goes up or down depending on the company’s performance. 

Financial statement analysiscomprises analyzing the following ratios under each heading:

• Cash Flow Statement: EBITDA (Earnings before interest, taxes, depreciation, and amortization) 
• Income Statement: Interest Coverage Ratio, Net Profit Margin, Operating Profit Margin, and Gross Profit Margin
• Balance Sheet: Debt to Equity, Receivables Turnover, Quick Ratio (cash and liquid assets to accounts receivables), and Asset Turnover

When creating a budget for your company after financial analysis, you need to factor in the different risks that could affect your performance. A financial risk analyst will help you create an accurate budget by considering the economic and regulatory risks. Revenues will be stated after accounting for these risks.

Here are some risks you need to consider:

• Credit Risk: If accounts receivables default in payment, provisions need to be made. 
• Currency Risk: If you are an exporter, currency risks are identified and hedged through derivatives. 
• Market Risk: A sudden fall in demand due to a market crash needs to be protected through reserves. 

Now that we know what risk analysis is all about let us understand the different types of risk analysis.