Measurement of risk in financial management
Every entity runs on finance - that goes without saying. Without either debt or equity, a company and its entities couldn't run. Yet, with financing comes risk, and it's important for financial managers to understand the levels of risk within their remit in order to manage that risk effectively.
The level of risk in financial management refers to the way a company or group is structured, and how money, equity or debt flows within the structure. Financial risk ratios are used to assess a company's capital structure and current risk level in relation to its debt level; how that company can manage its debt effectively is considered critical to its financial soundness and operating ability.
But what do we mean when we talk about risk in financial management? How can we measure that risk? And why would we want to measure risk in financial management?
The types of enterprise risk
When considering measurement of risk in financial management, we need to first separate financial risk from the business risk. Each type of risk should still be monitored, but one is more fixed than the other.
Business risk is tied to a company's fixed costs - those costs that always have to be paid regardless of what's happening in the business, like costs tied to real estate, utilities and wages. While these costs are fixed, a business's income is more variable. Some companies have fairly predictable income patterns, such as those based on subscriptions, whereas others are tied to market fluctuations. The latter companies have more business risk than the former - income against expenditure reveals the business risk.
Financial risk, on the other hand, is related to debt. As a company grows or needs a cash injection, it may turn to debt to finance operations. Its ability to pay off this debt is referred to as its financial risk - if the firm didn't take the debt, there would be no financial risk. A company then manages its financial risk by lessening its debt burden, perhaps by increasing equity financing.
There are three main types of risk in financial management:
- Credit risk, the most common type of risk in financial management, happens when a company can't pay its debt
- Liquidity risk happens when a firm isn't able to sell an asset quickly
- Equity risk centers around market volatility - when the market is volatile, it's difficult to attach value to equity stocks
Financial managers may also want to consider the risk of default on debt, the risk of interest rate fluctuations, and the risk of a decrease in purchasing power.
Factors impacting entity uncertainty
When assessing risk for measurement, there are many factors to consider. What can you do in case of:
- The product or service offered by the business becoming irrelevant, obsolete or disrupted
- A decline in demand for the goods or services produced
- Price fluctuations
- Inflationary tendencies
- Foreign exchange restrictions
- A change in government policy relating to business
Financial managers looking at risk measurement should also consider the financial leverage of the company structure. How dependent is the group or any of its entities on debt that has been issued? Financial leverage shows how the company is using debt as part of its financing strategy, which is important to know when measuring risk.
Options for measurement of risk in financial management
While business risk is usually measured by looking at the contribution margin as a percentage of total sales, or at the ratios of operating leverage effect, financial leverage or a combined leverage ratio, measurement of risk in financial management is a different story.
Financial risk looks at the ability of a firm to pay off debt - at how risky its capital structure is - and gearing and leverage are important factors in determining this risk. A structure with high leverage or high gearing therefore carries high financial risk.
Some equity investors are willing to take that risk on the promise of greater returns, and businesses that have an inherently low-risk model often consider adopting some financial risk to get equity returns to a more attractive base.
Let's take a look at some of the more common ways to measure financial risk in a business. It's worth noting there is no single measurement that will suit every sector and every business, so risk measurement should always be considered in the context of the business and sector itself.
Debt to asset
Given financial risk is associated with a company's debt, the obvious and easiest option for measurement of risk in financial management here is to look at its ratio of debt to assets. How much does the company owe, and how much does it earn? If it owes more than it owns, then the financial risk is greater; if it owns more, though, it could be an attractive prospect for investors.
Debt to income
Likewise, financial managers may wish to look simply at the income of a company instead of its assets, particularly if the portfolio is small. The debt to income ratio is measured as either net or gross debt divided by earnings or EBITDA.
Debt to capital employed, or debt to equity
Generally used in high-risk financial management scenarios, the debt to capital employed measure looks at the proportion of assets in a structure that are financed by debt. It's similar to a debt to equity ratio, and is measured in the same way, mathematically.
Interest cover
A measurement of risk in financial management that's employed in low-risk scenarios, the measurement of interest cover is worked out through the formula of earnings or EBITDA divided by interest.
Cash flow to debt
Another measurement device for low-risk businesses, cash flow to debt is measured simply as cash flow to service debt divided by debt. There are variations on this ratio, but this is the most often deployed and most simple usage.
Equity multiplier
Also known as the financial leverage multiplier, this measurement of risk in financial management measures the amount of a firm's assets that are financed by its shareholders. It compares total assets with total shareholders' equity to show the percentage of assets that are financed by equity shares. By extension, it also highlights the level of debt financing used to acquire assets and maintain operations.
Accessing data for measurement of risk
The good news for financial managers is that all of these measurements involve data that exists today - but in order to measure risk in financial management effectively, it's important to ensure you're using reliable data. The most important attributes in any measurement of risk in financial management are generally accuracy and precision.
