Basic Concepts of Financial Risk Management

Why This Matters?

Investors have picked stocks based on industry-company model for a very long time. This model forms the core of fundamental analysis. There are thousands of companies listed on Indian exchanges. Trying to pick a handful of them to invest in is comparable to finding a needle in a hay stack. You’d be completely lost. The industry-company approach, frequently referred to as the top-down approach, lends a structure to the research.

We mention some of its benefits below:

• Calibrated Approach :

The top-down approach looks at the broad trends in the economy and uses them to select specific sectors that should do well. Then, it allows you to zoom-in further, to the level of specific companies within the industry, and choose the best ones.

This gradual approach leads you to the right set of companies in a very sound and orderly fashion, without compelling you to look at every company in exhaustive detail.

• Provides Insight Into The Future :

The top-down approach doesn’t only involve an analysis of the past data. It also uses relationships thus discovered, to comment upon the future performance of the company. In most cases, investors use past data to extrapolate, i.e. project the future performance of a company. This is important because current stock prices are a function of the expected future performance of a company. If you can predict it somewhat reliably, you can judge as to whether the stock is worth buying at present or not.

• Facilitates Risk Determination :

If you can understand the factors that drive stock prices and make a reasonable assessment of what the future might hold, it is easier to also determine what might go wrong. This is one of the greatest benefits of the top-down approach. It helps you sniff out the red flags regarding a company’s future performance in advance and act on them. One doesn’t have to burn his hands later to realise what he shouldn’t have done. He can do it in advance.

Naturally, some events, such as acts of god, cannot always be foreseen and guarded against. In such cases, one has to act impromptu. However, a lot of warning signals with respect to a company and industry are visible in advance.

• Enables Informed Decision Making:

This approach is empirical in nature, i.e. it is based on profound experience and analysis. It allows you to use current and past data and discover relationships between factors both, at the industry and the company level. This is the basis on which you can form an opinion on the prospects of a company and decide whether to buy a stock at the current price.

For example, one may determine the impact of a change in a particular factor on the sales or profits of a company based on the impact that it has had in the past. This assessment uses both qualitative and quantitative aspects. In other words, a top-down approach makes company performance and price movements predictable to some extent. You can feel much more confident about your investment decisions when they are based on such an approach.

• Provides A Broader Perspective :

When you start right from the top of the tree, your sphere of analysis incorporates all the industrial sectors in an economy. This is akin to taking a hawk’s eye view of the economy to pick the best sectors.

Drilling down further by analyzing each of these specifically, then allows you to decide which of these is going to perform well under what market conditions. You can diversify accordingly and reap the benefits of a stable return in all market conditions.

• Aids Active Portfolio Management :

Earlier, we established that the top-down approach broadens ones perspective and brings all companies and industries into the fold of his analysis. This allows him to change the allocation of his portfolio according to the developments that take place in the economy.

No matter what the market conditions, you can always find something that will do well. Accordingly, you can increase the weightage of such stocks in your portfolio and earn extra returns.

What Are Business, Financial Risks

The top-down approach is not infallible. Things can always go wrong. Sometimes, unexpected occurrences change the outlook for an industry/company completely and catch you off-guard. The ability of such events to induce a divergence from the expected performance of a company. This is called risk. It must be noted though, that divergence can be positive and negative. When we assess risk, we are predominantly concerned about the negative events that lead to negative divergence. For a business, risks have been divided into two categories – business risk and financial risk. We will take these up individually.

• Business Risk :

The impact of market conditions and a company’s internal operations on its profits is called business risk. There are two types of business risks – sales risk and operating risk. Let’s look at them one by one.

• Sales risk:

The sales revenue of a company is a product of the price at which it sells its products and the quantity of them it is able to sell. Any change in these will result in a change in a company’s sales revenue. Sales risk is higher for companies with a higher fixed cost structure and greater price elasticity. Fixed costs are costs that a company has to incur irrespective of its level of output. High fixed costs make it hard to cut prices, even when production is low. Any reduction in price will make the company unable to cover its production cost. This inability affects its sales. Price elasticity of demand is the extent to which the demand for a product changes when its price changes. For companies with a higher elasticity of demand, a small increase in price leads to a greater fall in demand. This results in a fall in overall sales revenue. Thus, such companies find increasing prices harder. All other factors that impact a company’s ability to increase prices and level of output also fall under this category of risks.

• Operating risk :

Operating risk refers to the change in a company’s earnings due to internal factors. While sales have a direct impact on a company’s income, these factors have an indirect, although just as strong an effect. Operating risks are caused by anything that can lead to an internal breakdown in the company’s operations. Companies that have very old assets and don’t have strong, time tested structures in place are at the highest operational risk.

• Financial Risk :

Financial risk refers to the risk of a fall in profits due to high financing costs. The revenue a company earns trickles down as profit after a deduction of many expenses from it. One of these expenses is the cost of debt, i.e. interest a company has to pay on the money it has borrowed. This amount is high if a company borrows a lot of money. It has to be paid irrespective of the level of sales it is able to muster.

Thus, holding all other things constant, a company’s profit percentage gets magnified in the year when its sales revenues are high. This is because interest cost doesn’t increase proportionately to sales. Similarly, in the year when its sales revenues fall, there is a greater fall in its profit percentage owing to a constant interest cost. This is called financial leverage.

Let’s look at an example. Suppose a company earned Rs 1,000 this year. After deducting a fixed interest amount of Rs 300, its profit would come out to Rs 700. Now, suppose its sales increase by 50% to Rs 1,500 next year, subtracting the same amount of interest, its profit would be Rs 1,200. This is an increase of 71.4% from the previous year, i.e. greater than the increase in sales. Now, assume that the company can only manage sales of Rs 800 next year, i.e. a fall of 20%. Its profit for the year would now be Rs 500, implying a fall of 29%, greater than the fall in sales.