Risk management : Brigham, Ehrhardt and Stulz’s views (I)
All firms engaged in business are exposed to risk in one way or the other. For instance, a firm may be concerned about the effects of expenses and sales for which it has contractual commitments.
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A firm may be exposed to all, or some of the following risks: Interest rate risk, foreign exchange rate risk, and commodity price risk. Unfavourable changes in interest rates, foreign exchange rates, and commodity prices may have adverse effects on the firm’s market value. The firm is said to be strategically exposed (Smithson and Smith’s strategies as cited in Chew, 2001) when it is susceptible to the foregoing risks. Terrorist attacks in the United States, France, Belgium, Tanzania, Kenya and in some other countries across the globe in recent years have increased most firms’ exposure to risk.
It is believed governments would intervene to ensure companies are adequately protected. The assurance of adequate coverage would encourage private and public companies to remain in business to stimulate the economy and stem the tide of unemployment and economic stagnation. Some economic and social analysts perceive the demise of Osama Bin Laden, the renowned terrorist leader, as a bold step toward minimising the risk associated with terrorist attacks.
A firm’s exposure to risk makes it imperative for managers to identify useful ways of preventing or minimising its impact. In other words, it behoves managers to introduce measures that would ensure effective management of foreseeable and unforeseen risks. The term, risk management, has gained prominence in corporations over the years. From a financial perspective, the term is used to explain financial managers’ ability to identify financial transactions that could impact negatively on their firms and take the necessary steps to curb or minimise the transactions’ effects.
There is a paradigm shift from firms’ traditional focus on only insuring their property against burglary, casualties, fire, and full liability coverage to include hedging against essential commodity inputs, interest rates, and foreign exchange rates. It is the duty of financial managers to ensure measures taken to hedge against risk do not compound the company’s risks. The main purpose of this section is to discuss the views of Brigham and Ehrhardt (2008) and Stulz (as cited in Chew, 2001) on risk management.
Forms of risk
The complexity of the business environment makes it difficult for managers to effectively predict into the future. It is difficult for managers to foresee the organisational issues they would have to deal with in future. As a result, it is imperative for firms to engage the services of individuals who could identify potential organisational issues and develop measures that would prevent or minimise the dangers involved. Individuals entrusted with such responsibilities in organisations are called risk managers. In large organisations, the risk manager is answerable to the chief financial officer (CFO) whereas in small organisations, the chief financial officer usually incorporates risk management into his or her main functions.
The role of risk management in the financial success of organisations, both large and small, cannot be overemphasised. This makes it necessary for us to identify and discuss the types of risk the firm may be exposed to. Examples of risk include input risk, property risk, pure risk, financial risk, demand risk, insurable risk, environmental risk, liability risk, speculative risk, and personnel risk. Although these examples may not be identical in all industries, they provide us with a fair idea on the various forms of risk the company may face. Each of these types is described as follows.
Input Risk: This relates to risk identified with the costs of input such as materials and labour costs. If a firm uses oil as a major raw material in its manufacturing process, it may face an input risk when the price of oil increases and it is unable to pass the increase on to its customers.
Property Risk: This explains the probability that the company’s operating assets such as building and equipment would be destroyed by floods, riots, or fire. The likelihood that any of these unfavourable events would occur places a risk on the company.
Pure Risk: This concept is used to explain risks that have the prospects of resulting in losses to the company. Examples are the risk that a building will be destroyed by flood or that a legal suit on health hazards will result in the imposition of heavy fines on the company.
Financial Risk: It is the risk that is expected to emanate from the company’s financial transactions. Fluctuations in interest rates and foreign exchange rates are examples of financial risk that the firm would have to deal with. These fluctuations could result in unexpected losses to the company.
Insurable Risk: A risk that could have an insurance coverage is known as an insurable risk. Brigham and Ehrhardt (2008) state, it is possible for companies to transfer risks such as environmental, liability, property, and personnel risks to insurance companies. The authors note the firm’s “ability to insure a risk does not necessarily mean the risk should be insured” (p. 835). It is the responsibility of the risk manager to evaluate all existing alternatives and then choose the most cost effective alternative for the company.
Environmental Risk: Any risk emanating from environmental pollution is called environmental risk. The clarion call by the Environmental Protection Agency (EPA) on the need for us to maintain clean and safe environment, coupled with the high cost of cleaning, makes the environment one of the most significant risks faced by the company. Obvious examples in recent years are the huge costs involved in cleaning up the environment due to the oil spill by British Petroleum (BP) in the United States of America and gas explosion at the Ghana Oil (GOIL) gas station at Adabraka in Accra, Ghana.
Liability Risk: Legal actions taken by employees (on job safety, unfair wages, incentives, and so forth) and customers (on quality of services or goods, non-delivery of services or goods on schedule, among others) may result in a liability risk to the company. For instance, the courts may impose heavy fines on the company when its employees sustain injuries in the workplace. Similarly, the courts may enter judgement in favour of a patient whose surgery was not well performed by a surgeon, and which results in temporary or permanent deformity.
Speculative Risk: Although a firm’s analysis of a particular investment indicates positive returns, the end result of that investment may be a negative return. When this situation exists, there is a speculative risk.
Personnel Risk: Sometimes employees may engage in actions that would expose the company to risk. Examples include embezzlement of funds, fraud perpetuated by employees and legal actions as a result of discrimination on gender or age. The probability that any of these situations could occur means the company is susceptible to personnel risks. — GB
The writer is Lead Consultant/CEO,
Eben Consultancy,
Fellow & Council Member, ICEG
Email: [email protected]
Website: www.ebenezerashley.com