Financial risk of an enterprise can be defined as the probability of adverse financial consequences in the form of loss of income and capital under uncertainty conditions for its financial activity. Financial risks have a great variety and for the implementation of effective management are classified by several main features that will be considered below.
Financial risks arises in the process of enterprise relationships with financial institutions (banks, financial, investment, insurance companies, stock exchanges and others). Causes of the financial risk are inflation factors, the growth of bank interest rates, reduction of the value of securities and others.
Financial risks are roughly divided into two types:
1) risks associated with the purchasing power of money;
2) risks associated with an investment capital (investment risk).
Risks associated with the purchasing power of money involve risks of the following varieties: inflationary and deflationary risk, currency risk, liquidity risk. Inflation means depreciation of money and, consequently, rise in prices. Deflation is the reverse process of inflation, it is reflected in lower prices and, consequently, an increase in the purchasing power of money.
Inflation risk is the risk that, with increased inflation rate, cash income depreciates in terms of real purchasing power faster than it grows. In such circumstances, the entrepreneur carries a real loss. Deflationary risk is the risk that with increase of deflation, there occurs fall in the price level, the deterioration of economic conditions and reduced business income.
Currency risk is the risk of foreign exchange losses related to the change of one currency against another in conducting foreign trade, credit and other foreign exchange transactions. Liquidity risk is the risk associated with the possibility of loss on the sale of securities or other goods due to change of their quality and use value.
Investment risks include the following risks subspecies:
1) the risk of loss of profits;
2) the risk of profit reduction;
3) the risk of direct financial losses.
Risk of loss of profits - is the risk of indirect financial loss (loss of profit) as a result of non-implementation of an activity (e.g., insurance, hedging, investment, etc.). The risk of profit reduction may occur as a result of reducing the amount of interest and dividends on portfolio investment, on deposits and loans.
Portfolio investments relate to the investment portfolio formation and represent the acquisition of securities and other assets. The term portfolio is derived from the Italian Porte foglio in the meaning of aggregate value of securities that are available to investors. The risk of income reduction includes the following types: interest rate risk and credit risk.
Interest rate risk refers to the danger of losses by commercial banks, credit institutions, investment institutions as a result of exceeding the interest rates paid by their fundraising over the rates on the loans. Interest rate risk also includes the risk of loss that may be incurred by investors in connection with the change of dividends on shares in market interest rates on bonds, certificates and other securities.
Rising market interest rate leads to a decrease in the market value of securities, especially bonds with fixed interest. With increasing interest may also begin mass dumping of securities issued at a lower fixed interest and, by the terms of issue, prematurely taken back by the issuer. Interest rate risk is borne by the investor who invests in the medium and long-term securities with fixed interest at the current market average increase percent in comparison with the fixed level. In other words, the investor would receive income gains by increasing interest, but cannot release the funds invested on the above conditions.
Interest rate risk carries the issuer, who issues the medium- and long-term securities with fixed interest at the current market average percent decrease in comparison with the fixed level. In other words, the issuer could raise funds from the market at a lower percentage, but he is already bound by issued securities. This type of risk with the rapid growth of interest rates in an inflationary environment is important for short-term securities as well.
Credit risk is the risk of non-payment by the borrower of principal and interest owed to the lender. Credit risk concerns also the risk of such an event, in which the issuer that issued debt securities will be unable to pay interest thereon or principal payments. Credit risk can also be a form of direct financial loss risks.
Risks of direct financial losses include the following varieties: exchange risk, selective risk, the risk of bankruptcy, as well as credit risk. Exchange risks pose risks of losses from exchange transactions. These risks include the risk of default on commercial transactions, the risk of non-payment of commission and brokerage, etc.
Selective risks is the risk of incorrect choice of the method of capital investment, the type of securities for investment in comparison with other types of securities in the formation of an investment portfolio.
The risk of bankruptcy is a hazard due to incorrect choice of the method of capital investment, the complete loss of the entrepreneur's equity and his inability to pay by the undertaken obligations. As a result, the entrepreneur becomes bankrupt (Rampini, Sufi & Viswanathan, 2014).
Financial risk is one of the most difficult categories related to economic activity, which has the following main characteristics:
The economic nature. Financial risk is manifested in the economic activity of the enterprise. It is directly associated with the formation of its profit and characterized by its potential economic losses in the implementation of financial activities. Given these economic forms of its manifestation, financial risk is characterized as an economic category, occupying a certain place in the system of economic categories, related to the implementation of the economic process.
Objective manifestations. Financial risk is an objective phenomenon in the operation of any enterprise. Risk accompanies almost all kinds of financial transactions and all financial areas of the company (Christoffersen, 2012). Although the number of parameters of the financial risk management depend on subjective decisions, the objective nature of its display remains unchanged.
The probability of realization. Chance of categories of financial risk is manifested in the fact that the risk event may occur or may not occur in the course of the financial activities of the enterprise. The degree of this probability is determined by the action of both objective and subjective factors, but the probabilistic nature of financial risk is a constant characteristic.
Uncertainty of effects. This characteristic of the financial risk is determined by non-determination of its financial results in the first place, the level of profitability of financial transactions. The expected level of performance of financial transactions may vary depending on the level of risk in a rather large range. Financial risk can be followed by substantial financial losses for the company and its formation of additional income.
The expected adverse effects. Consequences of manifestations of financial risk can be characterized by negative and positive performance indicators of financial activity; this risk in economic practice is characterized and measured by levels of possible adverse effects. This is due to the fact that a number of extremely negative consequences of the financial risk are determined by the loss of not only income but also capital of the enterprise, leading it to bankruptcy (i.e. irreversible negative consequences for its activities).
The variability level. The level of financial risk inherent in a particular financial transaction or a certain type of financial activity is not the same. First, the financial risk varies considerably over time, i.e. depends on the duration of the financial transactions, as the time factor has an independent effect on the level of financial risk (manifested through the level of liquidity of invested funds, the uncertainty of movement of lending rates in the financial market, etc.). In addition, the indicator of the level of financial risk varies considerably under the influence of numerous objective and subjective factors that are constant over time (McNeil, Frey & Embrechts, 2010).
Subjective assessment. Despite the objective nature of financial risk as the economic effect, its main evaluation index is the level of risk, which is subjective. This subjectivity, i.e. nonequivalence evaluation of objective phenomena, defines different levels of completeness and accuracy of the information base, qualification of financial managers, their experience in the field of risk management and other factors.
The concept of risk situation can be defined as follows: all risky circumstances taken into unity and interaction; there are distinguished the natural state of insurance objects and furnishings (interdependent causal relationships), in which the object is located. The existence of risk is directly related to the uncertainty. Uncertainty implies factors, in which the results of operations are not deterministic, and the extent of possible impact of these factors on the results is unknown; it is incomplete or inaccurate information on the conditions of the project realization.
There are the following three types of situations:
- situation of certainty, where the choice of a concrete plan of action from the set of possible always leads to a known, accurately determined outcome;
- risk situation, in which the choice of a concrete action plan, in general, can lead to any outcome of their fixed set. However, for each alternative, there is known probability of realization of possible outcome, i.e. each alternative is characterized by a finite set of probability;
- the uncertainty characterized by the fact that the choice of the particular mode of action could lead to any outcome from a fixed set of outcomes, but the likelihood of their implementation are unknown. Here we can distinguish two cases: either the probability is unknown due to the lack of necessary statistical information, or about the objective probabilities.
Thus, the risk situation is characterized by the following features: the presence of uncertainty; the need to choose alternatives of action (it must be borne in mind that the refusal to choose is also a kind of choice); opportunity to assess the probability of the chosen alternative, as uncertainty in the probability of occurrence of events in principle cannot be determined.
Risk situation is a kind of uncertainty, when the onset of events is probable and can be identified. In other words, the risk is the estimated probability in any way, and uncertainty is something that cannot be estimated.
Speaking of uncertainty, it is necessary to note that it can manifest itself in different ways:
- in the form of probability distributions (the distribution of the random variable is exactly known, but it is not known what specific values take a random variable);
- in the form of subjective probability (the distribution of the random variable is unknown, but we know the probability of individual events, defined by experts);
- in the form of an interval of uncertainty (the distribution of the random variable is not known, but we know that it can take any value in a certain range).
Many financial transactions (venture capital investment, the purchase of shares, selling operations, credit operations, and others) are associated with a fairly significant risk. It is necessary to assess the degree of risk and determine its value. The degree of risk is the probability of occurrence of the event of loss, as well as the size of the potential damage from it (Cornett et al., 2011).
The risk may be:
- valid - there is a threat of total loss of profit from the proposed project;
- critical - possible not only non-arrival of profit, but revenue and losses at the expense of the undertaking;
- catastrophic - possible loss of capital, property and bankruptcy of entrepreneur.
Quantitative analysis is the definition of a specific amount of monetary damages of separate subspecies of financial risk and financial risk as a whole. Sometimes qualitative and quantitative analysis is based on assessment of the impact of internal and external factors: there is item-specific weight estimation of their influence on the work of the enterprise and its monetary value. This method of analysis is rather time-consuming in terms of quantitative analysis, but brings its undoubted benefits in qualitative analysis (Lins, Servaes & Tamayo, 2011). Because of this, we should pay more attention to the description of methods for the quantitative analysis of financial risk, because a lot of them require certain skills for their intelligent application.
In absolute terms, the risk may be determined by the magnitude of potential losses in material (physical) or value (monetary) terms. In relative terms, the risk is defined as the amount of possible losses, attributed to a base, in the form of which it is most convenient to take any property condition of the enterprise, or the total cost of resources for this type of business, or the expected income (profit). Then the losses will be considered random deviation of profit, income, revenue downward in comparison with the expected values. Entrepreneurial loss is primarily a random reduction of the business income. The quantity of such losses characterizes the degree of risk.
The method of avoiding the financial risk is to develop activities of such an internal nature, which would completely exclude a specific type of financial risk (Bessis, 2011). One of such measures is waiver of financial transactions, the level of risk of which is extremely high. Despite the high effectiveness of this measure, its use has been limited because most financial transactions are associated with the implementation of the main industrial and commercial activity of the enterprise, providing a regular flow of income and the formation of its profits.
Refusal to use a high amount of borrowed capital is another effective measure. Deleveraging of financial assets in the economic circulation helps to avoid one of the most significant financial risks - loss of financial stability. However, to avoid such a risk entails lowering effect of financial leverage, i.e. the possibility of obtaining additional amount of return on invested capital.
Avoiding excessive current assets in illiquid forms is also a way out. Increasing the level of liquid assets to avoid the risk of insolvency of the enterprise in the future period. However, this deprives the company of additional revenue from increased sales volume in the loan and partly creates new risks associated with the violation of the rhythm of the operational process of the reduction of the amount of insurance reserves of raw materials and finished products.
Avoiding the use of temporarily available cash assets in short-term investments. This measure allows for avoiding the deposit and interest rate risk, but generates inflation risk, and the risk of loss of profits. These and other measures to avoid financial risk despite their radicalism in the rejection of their individual species deprives the company of additional sources of income formation, and thus adversely affect the pace of its economic development and efficient use of the equity.
References
Bessis, J. (2011). Risk management in banking. John Wiley & Sons.
Christoffersen, P. F. (2012). Elements of financial risk management. Academic Press.
Cornett, M. M., McNutt, J. J., Strahan, P. E., & Tehranian, H. (2011). Liquidity risk management and credit supply in the financial crisis. Journal of Financial Economics, 101(2), 297-312.
Lins, K. V., Servaes, H., & Tamayo, A. (2011). Does fair value reporting affect risk management? International survey evidence. Financial management, 40(3), 525-551.
McNeil, A. J., Frey, R., & Embrechts, P. (2010). Quantitative risk management: concepts, techniques, and tools. Princeton university press.
Rampini, A. A., Sufi, A., & Viswanathan, S. (2014). Dynamic risk management. Journal of Financial Economics, 111(2), 271-296.
