Introduction
Companies, both financial and non-financial emerge with a specific set of objectives. Despite the outstanding differences in the objectives of various organizations, the presence of risk is not deniable. According to Marrison (2002, p. 36), all operations face a certain degree of uncertainty. The challenge facing the management of these companies is how to minimize the level of risk thereby achieving most if not all their objectives within the specified period. Financial companies are involved in the provision of credit to other companies, while non-financial companies engage in the production of goods and services to satisfy human needs and wants.
Non-financial companies aim at gaining a competitive edge in all functions. Due to the presence of a large pool of amorphous competition in the market, the products offered by non-financial should appeal to customers and satisfies their needs. The company management is mandated to structure and implement strategies relating to risk and capital management to enhance shareholders’ wealth (Servigny & Renault, 2004). Since risk and capital management functions in non-financial institutions are not closely interrelated, the management has to institute company-wide controls to avoid any slip-ups.
A survey by Bodnar et al (1998, p. 112) portrayed increased use of models for estimating risk profiles of projects by the surveyed companies. During the survey, increased awareness of the necessity to institute measures to combat risk was evident among large companies. Such measures were concentrated around the appraisal of new projects.
By incorporating risk management into companies’ strategy, companies are able to realize benefit emanating from more stable cash flows (Coyle, 2006, p. 213). Risk quantification and mitigation is most complicated in non-financial institutions among all operating companies. The variations observed in strategy formulation and implementation between different companies gives rise to the presence of a large pool of risk factors facing the operational facilities of a company. In addition to financial risks, non-financial companies face business risks, which are more diverse in nature (Linsmeier TJ & Pearson, 1996, p. 116).
Crouhy et al (2001, p. 205) points out that risk management systems for non-financial companies function to identify factors related to market risk. Such factors influence earnings’ volatility of each organization. Due to the multiplicity of these market factors, each organization should have a system that incorporates all market factors that are valid in its line of operation since none of the systems can cater for the intricacies of each organization. As a management tool, each organization should match profit and loss consideration with planning and budgeting for risk.
The amount of probable loss as well as the possibility of incidence of the loss defines risk as highlighted by Brachinger (2006, p. 3). In the presence of numerous risk factors, the overall risk exposure is a culmination of the multitude of the specific exposures. However, each risk category is considered in its own magnitude to avoid errors occurring from generalization.
Risk Definition
Non-financial companies require ample knowledge of the types of risk exposures facing their operations. As implied by Coyle (2001, p. 105), the specific goods and services offered by the organization will not affect the type of risk to which the company is exposed. Thus, defining the risks is the first and least-tasking requirements in strategic planning. In the course of operation, the company will be exposed to strategic, financial, operating and technical risks among others.
Strategic risk
As posted by Marrison (2002, p. 123), the duty of the top management of the company is to steer the company towards achievement of objectives. As a result, the strategies they present to the other levels of management determine the success of the company. The strategy formulation process is however clouded with uncertainties. Rarely does the management have accurate information about competitors and their strategies. For example, company A and B, both of whom deal in groceries, may offer reduced prices and home-delivery services in the same period in a bid to increase markets share. By so doing, the anticipated increase in cash flows for company A is thwarted by the action of company B. Alteration, modification of the strategy normally takes time, and resources, thus, the expected outcome will differ from the actual.
For new projects, the risks associated with strategy are more prominent since most of the cash flows projections are based on anticipated consumer behavior. Thus, as the management designs the strategies for entry into the market, the highlight of the process is the assumption that the variables do not change. Strategy risk occurs because of change in the normal business process associated with political, enterprise, market and regulatory entities.
Operating risk
The non-financial aspects of the company are the backbone of company strategy despite being subject to numerous uncertainties emanating from the nature of the business. The environmental factors are prone to change, thereby introducing variables that were unanticipated. For example, disruption of production cycle could compromise inventory levels. The management has to incorporate measures to avoid inventory depletion arising from upsets of the production cycle. Operation risk is therefore specific and restricted to a company.
Financial risk
New projects are faced with uncertainty in cost structures. The projected costs are based on forecast, which are prone to any changes in interest rates. Availability of credit determines the timely completion of the project since funds are the driving force behind any project. As observed by Crouhy et al (2001, p. 118), organizations face a major challenge in sourcing for affordable fund for their projects. The volatility of finance costs restricts the viability of projects deemed profitable. The implicit and explicit cost of finances underscores the attractiveness of most projects.
Technical risk
The dynamic nature of technology offsets the viability of numerous projects. In order to remain technologically up to date, an organization is pushed to the limit to cater for any anticipated changes (Crouhy et al, 2001). The competitive advantage accruing to technologically perceptive companies is beyond doubts. Reduced costs and superior quality are just but a fraction of the advantages of keeping-up with technology. However, as posited by Stein et al, (2001, p. 128), the project life cycle is subject to changes in technology. Newer and more efficient technologies shift benefits to competitors, thereby necessitating additional investment.
Risk Measurement
Estimation of risk is a necessary step for effective risk management. The amount of risk anticipated calibrates the resource allocation to cater for any deviations. Since not all risks are manageable, the management should channel resources to risk management strategies that add value to the organization. Risk measurement approaches include Cash-flow-at-Risk model, Monte Carlo Simulation and the Variance-Covariance approach.
Cash-flow-at-Risk Model
As proposed by Stein et al (2001, p. 103), the Cash-flow-at-Risk (denoted ‘C-faR’), also known as historical simulation, is the most appropriate measure of risk associated with operations in a non-financial company. Through this method, the management can approximate, at different levels of confidence, the probability distribution of the organizations future revenues by relying on past performance.
As suggested by Marrison (2002, p. 11), CfaR for any given organization is challenging to construct. This is a result of the variations in strategies from one organization to another. By using the past performance of the specific item faced with risk instead of the operations undertaken, an organization fully incorporates all facets of risks. This method, referred to as tops-down method, provides the most accurate measure of exposure to risk since cash flows are a result of all functional operation of the firm.
Such a method relies on benchmarks to designate the risk profile of the organization. Choice of the benchmarks occurs based on capital structure, profitability, industry characteristics and volatility of share prices (Coyle, 2001). Thus, it is advantageous to benchmark with companies in same industry having similar characteristics. By so doing, cash flow estimates are moderated since averages are used.
However, adjustments to accommodate the intrinsic characteristics of the project should appear in the final estimates. Such adjustments cater for risk exposures that are not duplicated across the projects compared. For example, if unlike project B, A is involved in production for export, foreign exchange risk will not affect B as it has A.
New projects with characteristics of existing projects present an easier challenge than novel projects. Crouhy et al (2001, p. 134) asserts that the organization can simulate expected risk levels from the historical data of the successful project. Data from other organizations can also be used incase a similar project was undertaken. As earlier mentioned, care should be taken to adjust the estimates for the intrinsic characteristics.
In order to arrive at a feasible risk profile for project, the management needs to determine the specific risk exposures facing the project. By so doing, the management collates the risk factor into their categories with the aim of obtaining the net effect. Lack of historical data leaves the management with the option of sourcing secondary data in addition to simulated models. The estimated cash flows are the subjected to standard probability levels to obtain the expected values. The sum total of the outcomes becomes the value of risk.
Variance-Covariance approach
Brachinger (2003, p. 4) asserts that market factors have a normal distribution. Under this assumption, the variance-covariance approach approximates the levels of risk for each scenario. Related risk factors are mapped into same categories for ease of operation. By so doing, the management arrives at a matrix depicting the covariance of the expected cash flows. Using the matrix, the standard deviation of the project is calculated using the standard deviation formula.
As echoed by Linsmeier & Pearson (1996), this method presents an avenue for standardization of risk profiles for all projects undertaken by the organization. As a result, the management maintains sufficient risk management measures for each project. Similarly, it simplifies the understanding of risk to all stakeholders since all projects bear same characteristics of risk. In addition, since the risk exposures emanate from operations of the organizations, measures to counter exposure to risk are standardized across all projects undertaken by the organization.
However, projects whose characteristics deviate from the currently operational ones pose different risk features, thus have to be mapped onto the matrix. As a result, the risk matrix should contain only those projects with similar sensitivity to market factors. This method is most appropriate for projects with short life cycles, since factors used in construction of the matrix will not vary greatly in the short-run, for example one year.
Monte Carlo Simulation
This form of simulation bears semblance to the C-faR approach. However, instead of using historical data, the hypothetical cash flows are subjected to random numbers representing changes in the market factors (Linsmeier & Pearson, 1996). These random numbers represent the unpredictability of the future cash flows. The management is at liberty to choose the extent of simulation. From the expected values, the company estimates the value of risk.
After deciding on the project to test, the management has to agree upon the number of simulation runs to undertake. By choosing the appropriate parameters, the management achieves its goal of matching the project characteristics with the appropriate risk factors. From the risk levels obtained, the management chooses the acceptance criteria based on deviation from the averages. The simulation method, just like C-faR is most suitable for project with a long life cycle. The use of simulation enables the management to accommodate wide-ranging changes, which are common in the long term.
Risk Management
Crouhy et al (2001) emphasizes that since risk originates from operating activities, any measure laid down by the organization center around those functions that expose to risk. Careful analysis of each function reveals the instances that can compromise achievement of strategic plans. As a point of note, each of these functions has either a positive or a negative eventuality. The management has to thus reduce adverse variances while maximize on the favorable outcomes. The risk management approaches available to management include operating leverage, production location, volume/product mix and diversification.
Operating Leverage
As suggested by Sadgrove (2005, p. 56), the anticipated costs and cash flows estimated during investment appraisal are adjusted for inflation. By using the present value of the anticipated cash flows, the management is able to accommodate loss of value originating from implicit ad explicit costs. Use of discounting methods limits the disparity in the actual returns from the anticipated returns. Similarly, discounted methods of appraisal incorporate all cash flows from the project.
Production Location
Globalization has opened opportunities for organization (Servigny & Renault 2004, p. 45). The increased competition has pushed companies to use cost reduction as strategy for any projects. The availability of cheaper resources on a different geographical location offers an avenue for reduction of risk exposure. By locating production facilities near raw materials or consumers, an organization reduces handling costs.
Geographical diversification of operational activities comes in hand during unforeseeable calamites. Organizations with centralized production facilities achieve lower costs of management but are prone to disasters as witnessed during the 9/11 attacks. During the Risk Management Roundtable (2001), emphasis was laid on shifting from reactive to a proactive model of dealing with risks. Cost benefit analysis is necessary for such types of proactive measures. An organization should appreciate the extent of the possible risk exposure and match costs with benefits (Saunders & Allen, 2002, p. 35).
Volume/product mix
Berwick (2007, p. 203) asserts that new projects face the task of cutting a niche in the volatile market. Thus, an organization cannot predict the actual market share since the response of the market to the product is not accurately measurable. Implicit characteristics not withstanding, some products fail to achieve the anticipated market share. To minimize risk related to production volumes, an organization should lay down measures to vary production according to demand levels.
Diversification
Servigny & Renault (2004) postulated availing a product range that satisfies a wide variety of needs that enables an organization to benefit from demand fluctuations. Product diversification is a strategic move by organization, which aims at increasing the customer base. Consumers will most likely consume different products from the same company if one of the products has satisfied their needs before (Sadgrove, 2005, p.265). Incase competitors’ strategy adversely effects one product, for example, through lower prices, the other product lines will act as cash cows and cushion the company from reduced revenues. New projects with elements of diversification offer the organization competitive edge thus reducing overall risk.
Conclusion
The responsibility for risk mitigation rests with the management of any organization. Since all actions propagating the risk are attributable to their strategy formulation, the management should lay down structure to safeguard against unexpected outcomes. Resources availed by the shareholders should be used in the most prudent manner with the aim of increasing shareholders wealth. As a point of note, the inability to provide for risk management amounts to poor corporate governance practices, responsible for failure in previously successful ventures. Thus, the management should clearly display their efforts to combat uncertainties initiated by their decisions.
References
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Linsmeier, T. & Pearson, D., (1996), Risk management: an introduction to value to risk, Web.
Marrison, C., 2002, The Fundamentals Of Risk Measurement, McGraw-Hill Professional, 2002 New York
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