The issue of risk in non-financial companies - Free Essay Example

Risks have always been at the centre of business activities. Risks were routinely accepted by traders in historical times, as well as by commercial expeditions in post-medieval periods. They are similarly now being faced by a range of modern day businesses in the course of their operations for the fulfilment of their objectives. (Buljevich, Park, 1999, P 1)The systematic management of risk is not a new phenomenon either; insurance companies specialising in making money out of methodical risk identification, assessment and management have now been in existence for more than a century (Buljevich, Park, 1999, P 1). Apart from insurance companies, other financial organisations like banks and financial institutions also deal with risk as part of their mainstream activity and approach the issue in a planned and methodical manner (Buljevich, Park, 1999, P 1). The issue of risk in non-financial companies however takes on different dimensions (Carlton, 1999, P 83 to 107). Whilst the activities of non-financial companies do not specifically call for continuous application of risk management techniques, many of their major activities, (like selling goods in the market place, buying material or services from external vendors, procuring and applying new technology, opening new branches, or putting up new factories) , involve significant elements of risk (Carlton, 1999, P 83 to 107). It is also widely accepted by management and financial experts that modern day, non-financial business corporations need to often engage in activities with high elements of risk (Esty, 2004, P 213 to 224). The contemporary business environment is much different from what it was even two decades ago. Globalisation and economic liberalisation, along with the dismantling of physical and economic barriers, astonishing technological progress, the emergence of instantaneous communication technology and the spread and sophistication of the internet have led to the creation of enormous business opportunities for commercial firms (Esty, 2004, P 213 to 224). Business organisations who were in the past content to grow in set patterns along reasonably pre-determined routes are now faced with a bewildering range of business opportunities (Esty, 2004, P 213 to 224). Modern day businesses are also shedding the inhibitions, apprehensions and constraints of the past and engaging in substantial expansion and in new projects, both on a local and an international basis (Esty, 2004, P 213 to 224). Cross country investment and trade has expanded dramatically. Whilst a few companies like McDonalds, Coca-Cola and some other iconic organisations were in the past associated with extensive international activities, a number of UK based companies like Tesco, Mark and Spencer, Costas Coffee, and Next, are steadily increasing their global footprint. Although business opportunities have exploded in contemporary times, and modern day businesses are exploiting them aggressively, such opportunities do entail significant risks (Carlton, 1999, P 83 to 107). Non-financial organisations are also under pressure, not just from their share holders, but also from the larger, high pressure, and fast changing economic and competitive environment to engage in new projects with various degrees and dimensions of risk (Carlton, 19 99, P 83 to 107). Risk management is now one of the most important activities of non-financial organisations, albeit not in the way it is for banks and other financial companies (Carlton, 1999, P 83 to 107). This study deals with the various risks that are faced by non-financial companies engaged in new projects, the identification, measurement and management of such risks and the importance of effective risk management for organisational security and success (Carlton, 1999, P 83 to 107). 2. Identification of Risk Contemporary businesses engaged in setting up new projects are likely to face risks of diverse types and with different dimensions (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). It is thus important for such organisations to formulate and develop efficient systems of risk management (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Effective risk management systems start with construction of processes for systematic identification of risks (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Risks associated with new projects can broadly be classified under the broad categories of operational risks, financial risks, market risks and reputational risks (Carlton, 1999, P 83 to 107). With such categories however being too broad for actual measurement and management, most firms isolate and identify risks under the more specific and narrower categories described below (Carlton, 1999, P 83 to 107). Market Risk Market risks concern the market demand for products or services that are proposed to be generated by new projects (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). The market demand originally assessed and projected at the time of preparation of feasibility studies, can be adversely affected by unavoidable increases in costs, the development of more effective or economical substitutes, alterations in customer industries, and political or environmental developments (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). The economic recession that set in towards the middle of 2007 and continues even today affected the fortunes of many new projects (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). With market demand for products and services diminishing sharply in the wake of the economic recession, new projects in the UK, as in many other parts of the world, took a severe beating (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Operating Risks Such risks concern the different resources that are required for the successful operations of new projects (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). They can emerge from factors that are controlled by organisational managements like labour and cash availability, or be caused by external factors like fluctuations in exchange rates or faults in design, planning or construction (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Risks of this type can lead to the surfacing of problems that could make it difficult for new projects to meet their scheduled output of products or services (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Completion Risks Completion risks refer to the possibility of projects getting delayed because of various factors like unavailability of essential material, labour unrest, delayed delivery of supplies and equipment, delays in disbursal of bank loans, and even inclement weather (Carlton, 1999, P 83 to 107). Inflation Risks Inflation risks can arise from actual inflation rates exceeding the rates projected at the time of preparation of feasibility studies (Carlton, 1999, P 83 to 107). It is pertinent to note that the unprecedented increase in oil prices during 2007 adversely impacted the progress of numerous big and small new projects across the world (Carlton, 1999, P 83 to 107). Currency Risks Currency risks are essentially part of the operating and construction risks of new projects (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Such risks arise when the inflows and outflows of a project are denominated in different currencies (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Unexpected and sharp exchange rate fluctuations can severely affect the operations and profitability of such ventures. New projects that are overly dependent upon export or import of goods or services are likely to be more exposed to such risks (Wibowo, Kochendà ¶rfer, 2005, P 963 to 972). Political Risks Political risks are important for new projects that are proposed to be put up in other countries with different political environments (Carlton, 1999, P 83 to 107). Whilst most business organisations are reluctant to invest in new projects in politically volatile areas, competitive pressures and the need to get early entry in attractive markets often force business organisations to invest in new projects in politically sensitive countries (Carlton, 1999, P 83 to 107). Apart from arising out of political volatility, such risks could emerge from the possibility of legislative or regulatory changes in host countries leading to significant changes in market conditions (Carlton, 1999, P 83 to 107). To elaborate, businesses in the United States have been engaging in substantial outsourcing of activities for improving their competitive advantage. The ongoing recession is however forcing US policy makers to enact legislative changes for protecting American jobs, which in turn could have significantly adverse results on the many Asian companies who have invested in new projects for supplying offshore services to the Unites States. Regulatory Risks New projects in regulated areas like supply of water or power, or the construction of toll roads, often face uncertainties about the future pricing of their products or services. Whilst the initial paperwork for such projects includes clauses regarding the future pricing of generated services, it is not uncommon for such agreements to be adversely impacted by regulatory change. The huge Dabhol Power Project set up in Western India by Enron in the late 1990s came to a virtual standstill because of sharp downward revisions in the price of generated power after the election of a new and hostile state government (Esty, 2004, 213 to 224). Other Risks Even the risks given above are illustrative and not exhaustive. New projects can be adversely affected by other causes like changes in technology or the possibility that the natural resources needed for a project may not be available (Carlton, 1999, P 83 to 107). Force Majeure risks represent a basket of unanticipated and practically uncontrollable natural or manmade conditions like floods, earthquakes, war or civil riots that can severely affect the operations and feasibility of new projects (Carlton, 1999, P 83 to 107). 3. Measurement and Management of Risks Whilst many of the risks detailed above are self evident and intrinsic to new business projects taken up by non-financial companies, a large number of modern organisational managements still do not take comprehensive steps for the management of such risks. A survey by Ernst and Young, a leading firm of management consultants, reveals that more than half of the CFOs and CEOs of major business firms appreciate that their organisations do not have comprehensive and systematic processes for managing their important risks (Izaguirre, 2009, P 1). In fact the majority of such companies tackle different risks individually, and whilst some standard precautionary methods are adopted, most risk control actions tend to be reactive rather than proactive and take place only after or during the development of risk environments (Priddy, 1999, P 1). Risk management experts state that non-financial companies need to adopt far more comprehensive and holistic strategies towards risk management, not just for new projects but as an integral component of modern day business activity (Carlton, 1999, P 83 to 107). Managements of new companies, at the time of initiation of new projects, need to not only exhaustively identify the various risks that are associated with new projects, but also investigate whether their organisations are taking the right risks, whether they are undertaking acceptable amounts of risk, and whether they are capable of taking action to manage such risks (Carlton, 1999, P 83 to 107). Apart from the need for identification of risks, risk management experts also point to the necessity of adequately measuring such risks, deciding whether the benefits from new projects are sufficient for organisations to accept such risks, and finally of taking specific and centrally controlled measures to manage such risks (Carlton, 1999, P 83 to 107). Investigation and measurement of risks primarily involves (a) getting to know the important risks that are being undertak en by organisations, (b) the relationships of such risks with the objectives and strategies of the firm, (c) the relationship of such risks with the creation of organisational value and (d) the connection of risks with enhancement of organisational competitive advantage (De Wit, 2005, P 2 to 25). Such an exercise if conducted methodically can help significantly in localising risks that need to either be compulsorily be taken for organisational benefit or otherwise be partially or totally avoided (De Wit, 2005, P 2 to 25). Business organisations usually measure risks by different methods (Priddy, 1999, P 1). Identifying and localising risks help businesses in deciding upon various project features and in altering and managing risk profiles to ensure that only risks necessary for organisation benefit are accepted (Priddy, 1999, P 1). Risks are measured through four main methods, namely the proxy method, the earning volatility method, the assessment method for loss modelling, and th e method for direct risk estimation (Priddy, 1999, P 1). Whilst the loss modelling method involves some amount of statistical work, the others are basically dependent upon the application of sound business sense to different risk bearing situations (Priddy, 1999, P 1). Such risk measurement enables organisational managements to predict the potential profitability of particular new ventures, locate areas of risk and take action either to avoid such risks or mitigate their potential impact (Priddy, 1999, P 1). Managements manage risks through the application of a range of strategic choices, organisational policies and operational actions after their identification (Carlton, 1999, P 83 to 107). Whilst the appropriate identification of risks can help managements in aborting excessively risky projects, they are also helpful in increasing managerial focus on specific areas and take appropriate risk mitigation actions (Carlton, 1999, P 83 to 107). Such risk management methods are tai lored to meet specific sets of risks (Carlton, 1999, P 83 to 107). The management of operational and construction risks is generally met through very careful selection of suppliers and contractors, arrangement of adequate funds, obtaining of bank guarantees, and inclusion of penalties for contractual failures (Carlton, 1999, P 83 to 107). Currency and exchange risks are managed through forward hedging contracts (Carlton, 1999, P 83 to 107). Political risks are controlled through constant communication with policy makers and the use of political lobbies, if so required (Carlton, 1999, P 83 to 107). Environmental risks are controlled by ensuring compliance with regulatory requirements. Appropriate insurance also helps greatly mitigating business risks (Carlton, 1999, P 83 to 107). 4. Conclusion Non-financial companies face a wide range of risks in their regular business activity and more so during execution of new projects. Whilst financial companies look at risk management in a methodical manner and base most of their operational actions after the assessment of a range of risk criteria, non-financial companies tend to be ad-hoc, conventional, and reactive in their approach towards risk management. Modern day business environments, whilst brimming with opportunities, are however complex and risky, especially so for growth oriented firms. It is thus necessary for managements of such firms to put strong risk management measures in place to safeguard their investments and improve their competitive advantage.