Business and Financial risks must not be seen as watertight compartments in today's global business environment. In recent times, the concept of Enterprise Risk Management (ERM) has caught the imagination of CEOs and CFOs across the world. The essence of ERM is taking an integrated holistic approach to managing risks as opposed to a piecemeal approach. But the concept of ERM itself has emerged from a simple insight. Business and financial risks must not be seen as watertight compartments. They should be managed in an integrated fashion.
Where business risk is low, a firm can, and should take higher financial risk. On the other hand, when business risk is high, financial risk must necessarily be low. Business risk is nothing but the uncertainty associated with the operating cash flows of a business. A firm can never be certain how much of its products will sell, at what price, and the operating expenses that will be incurred in the process. These uncertainties are a direct outcome of the nature of business and the firm's corporate strategy. On the other hand, financial risk emanates from the use of debt. Since debt involves mandatory principal and interest payments, it is more risky than equity.
In case of equity, dividend payment is optional and the capital is rarely, if ever, returned to shareholders. So, the higher the debt equity ratio, the more the financial risk. Business risk varies from industry to industry. In case of evolving and fast-changing industries, risk is high whereas in mature businesses, uncertainties are less. In a given business, two firms may view financial risk differently. A more aggressive firm would use more debt, and a less aggressive firm, more equity. Business and financial risks are interrelated. Sometimes, the linkages are obvious and direct. In other cases, they are indirect. A few examples will explain the close connection between business and financial risks. Basic research is risky because it has a longer time horizon. Research-based companies often carry more equity on their balance sheets to reduce financial risk. As opposed to an R&D oriented company, a contract manufacturer, who licenses technology, assumes less business risk. So, it can afford to take more financial risk. |
