Risks
faced by shareholders in a business
Corporate musings by Ravi Mahendra
The basic idea behind finance is that all investments, unless they
are government securities, tend to have an element of risk attached
to them. Whenever there is risk, there is a need to earn an extra
amount of return in order to compensate for that risk which has
been taken. In the case of small investors, to whom I address these
articles, you may be risk averse and unwilling to undertake certain
investments if you were adequately aware of the risks involved.
Risks
faced by businesses can mainly be categorised into business risk
and financial risk whereas others such as political risk, economic
risk, and management risk may also be considered.
Business
Risk
Not all businesses are similar. Presently I manage a school,
whereas my previous employment was related to venture capital and
I find that the level and type of risks faced by both sectors are
in fact, incomparable. I am sure it would be obvious to everyone
that risks vary depending on the line of business selected. The
hotels in Sri Lanka face more risk than private hospitals, because
the hotel industry is dependant on tourist arrivals, which is influenced
by various local as well as foreign, factors most of which are beyond
the control of the management.
Financial
Risk
This risk depends on how a business is funded in the long run. There
are two types of funding available to a business, which are shareholders
funds (equity) or loan funds (debt). Equity leads to ownership and
profit sharing, whereas debt leads to repayment of interest and
capital. The Debt to Equity ratio is known as Gearing and as this
increases, the financial risk faced by the shareholders increases
as well.
A
highly geared company will be very vulnerable to bankruptcy or failure
if its profits and cash flows dip significantly since it will not
be able to pay interest and capital. The risks faced by highly geared
company shareholders are therefore high when compared to their counterparts
in low-geared companies.
Political
risks
Even though political forces affect all businesses, some
are more vulnerable than others. The hotels in Sri Lanka are affected
by local as well as international political and terrorist activities,
whereas the apparel sector is affected by the political forces in
the US and Europe.
Economic
Risks
Different industries can get affected by economic factors
in different forms. Firms which provide financial services are severely
affected by an economic downturn in a similar fashion to car dealers
in Sri Lanka. The export firms such as apparel and tea are dependant
on foreign economies. Importers are affected by the risk of exchange
rate fluctuations.
Management
risks
Increasingly, the risk faced by most businesses is from
the management teams themselves since they are in charge of managing
the business, and can sometimes be driven by other agendas.
The
latest news to hit the headlines was of Parmalat, the Italian Dairy
giant whose founder himself has admitted to committing fraud. Be
vigilant about where you put your money, because the wrong people
may be managing it, or in worse cases, misusing it.
Message to the investor
The investment which you are making may in fact have more risks
than you foresee. Ensure that these are risks that you are willing
to take and if you take them you are adequately rewarded. As the
English proverb goes "Still waters may in fact run deep." |
