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Defining financial risk

While investors look upon risk positively, managers tend to view risk as the opposite of profits. The dramatic rise in financial instability in recent years suggests that decision-making is not benefiting from this well-balanced approach. Dr. Aneirin Sion Owen FCA tries to define financial risk in businesses and outlines the difference between what investors and managers consider to be a risk

The collapse of Tesco share price from a high of 490p to a low of 170p is a reminder that financial risk is not confined to software development, robotics and diamond mining, but is a general phenomenon. To an extent, financial risk takes different forms in specific sectors, but its key characteristics are shared across all sectors. The difficulty is that the core characteristics of risk are not easy to define. A business involves different ‘stakeholders’ and the idea of multiple perspectives on risk is readily appreciated. However, stock market collapses and bankruptcies hurt everyone, so an agreed definition of financial risk robust enough to apply to all sectors and stakeholders is needed. The term ‘managing risk’ is popularly used, but, if risk cannot be defined, there is little value in talking about ‘managing’ it.

It makes sense to approach risk from the perspective of investors financing business start-ups and expansion. The ‘circuit of capital’ model, see below, illustrates a company’s financial cycle, and highlights the origin of risk.

The main driver of risk is clear: the more money spent by a company, the greater the risk. Money has to be spent on recruitment, training, equipment and supplies, before a product can be made and then sold.

Two other factors determine risk: the length of time between spending and receiving and the company’s initial cash balance. If start-up costs are mainly working capital in nature, rather than fixed, and can be recouped quickly, there is little risk. If it takes twenty years to recoup the initial cash spent, the risk is huge. A successful initial public offering (IPO) provides the initial funding for many growing businesses. Take an IPO where investors have paid $2 per share and 10,000,000 shares have been sold. If the company has a $20m cash balance, and a $5m budget for equipment with a further $5m for working capital, it does not seem risky, as plenty of cash is left in reserve. In summary, risk increases the more that is spent, the longer the wait and the less successful the IPO. When stock markets and IPOs boom, risk falls, as long as company investment in fixed and working capital remains unchanged.

In recent times, investors’ perspective on risk has been reshaped by the fact they can chose from a global range of possible companies, and can strike a balance between risk and return. The higher the perceived risk, the greater the potential return necessary to induce investment, and, consequently, modern investors think in terms of a positive correlation between risk and profit. Wealthy investors already have a full range of relatively safe investments, including cash on deposit, commercial and residential property, government bonds and a portfolio of shares. If a business has $25,000,000 invested in a range of safe assets, advisors naturally start to look at higher risk investments, even those that previously would have seemed reckless. Wealthy investors look upon risk positively.

Managers’ perspective on risk is different. They deal with the everyday reality of running a business, something that investors are increasingly detached from. Finance directors, in particular, agonise over gearing ratios and the working capital cycle and are acutely aware that the greater the amount of both inventory, debtors and fixed capital employed in circulation, the greater the risk, especially in the short run. Bearing in mind that, as costs increase, profits fall, managers tend to view risk as the opposite of profits. The higher a company’s spending, the lower its profits and the higher its risk. Therefore, while investors view risk positively, and positively correlated with profits, managers may take the opposite view that risk is bad and negatively correlated with profits.

Managers, of course, work on behalf of investors, so the investors’ perspective tends to dominate, but, at the same time, managers are employed for their practical skills and experience. Part of managers’ role is to highlight risks and limit them. As a result, there is a necessary and positive tension between investors’ and managers’ view of risk, and this should be viewed as a natural part of dealing with the unknown element of business risk. Debate and disagreement is a key part of corporate governance, and, in decision making, a balance is struck between optimistic and pessimistic views of risk.

The dramatic rise in financial instability in recent years suggests that decision-making is not benefiting from this well-balanced approach. The managers’ counter balance is not working and the rise of the IPOs is part of the problem. As investors pour money into risky IPO schemes, managers in those companies take this as a signal of an appetite for risk. If they have reservations about the level of risk, these will seem less important as investors’ funding increases. A business idea may seem to an experienced manager to involve a high level of risk, but, if investors are willing to put $20m into it, the manager is inclined to follow, not counter, investors’ exuberance. The scale of spending on fixed and working capital will tend to increase, reflecting investors’ enthusiasm.

When levels of IPO activity are high, managers will be encouraged to take on risks that at other times they would consider excessive. The ultimate source of financial instability is the fact that risk is attractive to wealthy investors, who are willing to invest speculatively. The role of managers as a counter balancing force is a crucial part of reducing financial instability, and accounting and financial training needs to highlight the dangers of adopting a positive view of risk. The rapid expansion of Tesco has now gone into dramatic reverse, highlighting the risks involved with global expansion and diversification. Tesco’s problems are gradually coming to light, but they are exemplars of a more widespread problem in financial risk management.

Dr Aneirin Sion Owen FCA is a committee member of Liverpool Society of Chartered Accountants and senior lecturer at Liverpool John Moores University.

Originally published in Economia on 14 October 2015.