Business Risk & Financial Risk. Report on the assessment between business risk and financial risk and the relationship between the nature of business and the level of gearing.

University Degree Business and Administrative studies

ABMF41415 Financial Management Nicole Lim Sheue Wei

To: Mr Lim Hock Ge

(Director)

From: Ms Tan Yen Yen

(Finance Manager)

Date: 27th November 2009

Re: Report on the assessment between business risk and financial risk and the relationship between the nature of business and the level of gearing.

Definition of business risk and financial risk

1.1 Business risk

Business risk refers to the risk that a company does not have adequate cash flow to meet the company’s day-to-day expenses. It also indicates company has the risk of making low profits. [6] Besides that, it could be due to the company’s business nature and the riskiness inherent in the company’s operations if the company did not use debt financing. This is the risk that a business will experience a period of poor earnings or even losses. [5]

1.2 Financial risk

Financial risk is the risk that a company will not have enough cash to meet its financial obligations. [7]This indicates the difficulties of company to repay its debts and interests and the additional risk placed on the common stockholders of using debt financing. Thus, business may go into liquidation.

Financial risk can be seen from other factors when the company could not pay its debt on the due date and could not repay to payables. Ordinary shareholders will probably expect higher return from their shares to compensate for a higher financial risk. [2]

The assets of a business must be financed somehow, and when a business is growing, the additional assets must be financed by additional capital. Nevertheless, the higher the debt, the higher the financial risk.

Assessment of business risk and financial risk

2.1 Business risk

In order to assess business risk, we may use the ratio analysis to find out. If there is a high percentage of operating gearing, then the company is exposed to a relatively high degree of business risk. Operating gearing is the extent to which fixed costs are used in a company’s operations. It measures the relationship between contribution and profit before interest and tax.[2] If the fixed costs are high, even a small decrease in sales can lead to a significant decline in return of equity. So, other factors held constant, the higher a company’s fixed costs, the greater its business risk.

Business risk can be assessing from the foreign risk exposure. If the company generates a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations. This could be happen in both retailing and manufacturing company which selling and buying material from or to overseas. It would reflect the company’s profit.

In addition, can assess business through survey and observe the company’s management and staff at all level to know the status of the company. Business risk assessment survey may conduct to collect more risk information from the managers and staffs.

2.2 Financial risk

...

This is a preview of the whole essay

2.2 Financial risk

Same as business risk, financial risk can be assessing through ratio analysis, but through different gearing ratio which is the financial gearing and interest cover ratio. Financial gearing measures the relationship between shareholders’ capital plus reserves’ and prior charge capital or borrowings or both.[1] If the company’s financial gearing ratio is less than its neutrality level of 50%, it is a low geared company. Otherwise, it is a high geared company. While the interest cover ratio measures financial risk in terms of profit rather than in terms of capital value. Generally, the interest cover is considered low if it is less than three times, indicating the profitability is too low to cover its interest. However, the interest cover of more than seven times is considered safe.

Other than ratio analysis, financial risk can be assessing through the company’s receivable collection period and payables’ payment period. Both of these periods should set at a reasonable period. The receivables collection period could not agreed in a long period, company should collect its debt as soon as possible. Thus, company will have enough cash to make payment to the payables. If the company could not collect its debt sufficiently, company may not able to make payments as company does not have sufficient cash. For late payment, payables could take legal action towards company. To obtain more cash, company will need to borrow from external parties, which indicates the gearing of the company will be increased. Thus, company need to pay interest on the borrowing which incurred more expenses. So, company’s financial risk will be increased.

Similar with business risk, financial risk can assess through the financial risk assessment. This would help to understand more about the company financial status. Moreover, these surveys could ensure company has an acceptable low level of financial risk.

The relationship between the nature of business and the level of gearing

3.1 Wonderful Wire & Cable Berhad (manufacturing company) & Hai-O Enterprise Berhad (retailing company)

As for the manufacturing company, the business risk may arise whether the company able to control the output prices. If the company has ability to adjust output prices when there are changes input costs, such as raw material, the lower the degree of business risk. Manufacturing company has the authorities to increase the selling prices of its products, when the raw material costs increases, subsequently company would not bear extra losses. Alternatively, company could not raise the selling prices when the raw material costs increases, the profit of the company will be reduce. Hence, company bears the business risk. For instance, there was a significant decreased in Wonderful Wire & Cable Berhad's sales which may due to unexpected and unprecedented escalating prices of copper and aluminium which seriously hurt the earnings of cable manufacturers in the country. On the other hand, retailing company, Hai-O Enterprise Berhad does not face this problem as the company does not incurred raw material costs as the manufacturing company. Retailing company get the final goods from the manufacturer and sell off the goods through branches, therefore retailing company does not have significant problem on this. The price of final goods that purchased from the manufacture is more stable.

Furthermore, for the manufacturing company such as Wonderful Wire & Cable Berhad, will need more finance in order finance its fixed assets. Due to its nature, manufacturing company need more assets to produce their products, so company need more fund to get assets and maintain the assets. Company may have not enough cash or fund to finance; in order to get more fund, short-term borrowings and long-term borrowings will be adopted. Therefore, the gearing of the manufacturing company will be higher than the retailing company. In 2007, Wonderful Wire & Cable Berhad has negative financial gearing which mean the company has very high accumulated losses. This is caused by the increased prices in copper and aluminium. Company’s equity unable to cover the borrowings, this could lead company into difficulties.

However, retailing company such as Hai-O Enterprise Berhad has high operating gearing might be due to the large inventory that the company need to keep in the warehouse. The inventory that kept in the warehouse need to be guard by security or managed by the staff, this may incurred more extra expenses. As we know that, operating expenses is the ratio of the company’s fixed cost to its total costs. Therefore, the Hai-O Enterprise Berhad has higher operating costs compare to financial gearing. Company have low financial gearing which mean company does not rely much on borrowings. This gearing indicates that this company is safe for investment.

In conclusion, Hai-O Enterprise Berhad and Wonderful Wire & Cable Berhad does not represent all the retailing and manufacturing industry. But, it has indicates that the companies need a good risk management to reduce their risk into an acceptable level. Thus, this could ensure the company able to run their operations smoothly without liquidation problems.

References

BPP, 2009. ACCA Study Text, Paper F9, Financial Management. United Kingdom: BPP Learning Media Ltd. Page 232

BPP, 2009. ACCA Study Text, Paper F9, Financial Management. United Kingdom: BPP Learning Media Ltd. Page 236
Hai-O Enterprise Berhad – Viewed on 27 November 2009. Available from: +
Wonderful Wire Cable Berhad. Viewed on 27 November 2009. Available from: +
Richard Pike and Neale, 2009. Corporate Finance and Investment (6th edition). United Kingdom: Prentice Hall. Page 235
INVESTOPEDIA. Business Risk. Viewed on 27 November 2009.