Financial and Risk Management Practice - Term Paper Example

Name Tutor Course Date Financial and risk management practice Introduction Organizations need to manage funds in a more effective and efficient way and thus employ financial management practices. The current financial and risk management aims at assessment which is an important component for organizations, however, it is necessary in the education sector and a principle driver to learning. According to Arnold (2007), risk and financial assessment employs an approach that equips students with innovativeness required in learning. This is achieved through the management functions, assessment techniques and procedures involved in the financial and risk management practice. This paper illustrates the assessment regime of financial and risk management practices and their efficiency and effectiveness in other sectors, organizations and to learners. Tapiero (2004) states that, risk and financial management is becoming an integral part of organizations moving from qualitative assessment to more actual quantitative assessments. Risk management contributes a high percentage of organization’s profitability through effective and efficient risk mitigation plans that reduces impact of losses on the organization or prevent occurrence of the loss (Hennie & Brajovic, 2009). It should be a continuous process since risks arise every time in different operations. Risk management plan should observe aspects of time and outline strategies and techniques through which risks are acknowledged and confronted. It also involves prediction of what is likely to happen in the future and how the organization will handle it. Risk management applies in buildings, business operations and organizational functions. Currently, countries’ governments provide regulations and legislative procedures that govern risk management within and outside businesses (Carpenter, 2012). Over the past decades, the benefits of international diversification have been extended to stock portfolios. According to Allen (2013), investors of international stock markets consider themselves enjoying the substantially higher return with less risk than investment in single market. Risk-averse investors tend to avoid risk and would rather invest in markets with fewer risks and a lower return than in markets with high risks but possibly better returns. The aspect of risk brings about need for financial management in investment projects and business enterprises. Financial management involves all aspects of efficient and effective control including managerial finance, and corporate finance (Fisher 2012). Companies need to evaluate their financial health and stability of their operations. Other than the top management level, financial calculation and evaluation is important for the overall company and its continuity. Managers need information from the finance unit in the resource allocation process and facilitate the routine operations of the company. According to McLaney (2011), financial ratio analysis aids in instilling confidence among managers while they manage the business resources. Given the financial reports and statements, related contents of the statement can be evaluated to identify business’ performance. Through this, managers can gauge the market performance, liquidity, efficiency, gearing and profitability of the company (Dun and Bradstreet Corporation, 2007). Financial management The current financial management involves financial operations like funds utilization and procurement which is planned for, organized to function together, directed and controlled so as the organization meets its financial objectives. Financial assessment involves employing financial analysis techniques such as ration analysis. Financial management process includes planning for finances where adequate funds are allocated and made available for the right project or undertaking at the right time that is required to achieve organization’s goals. This depends on if the goals are long-term or short term such as funds required investing on stocks and credit sales or increasing the organization’s product base and making new acquisitions (Brigham & Ehmardt, 2011s). Financial control involves critical evaluation of the financial assessment procedures and other financial business operations such as security of business assets and management operations so as to maintain focus. Lee et al, (2007) states that, the executive body in the organization should be considering stakeholders’ interests especially owners since they are the source of company’s capital and also in accordance with rules provided by the business so as to protect business finances. Financial decision making is another important element of financial management. Major decisions made in relation to organization’s finances include financing of projects and operations, shareholders’ dividends and investments. Investment decisions include methods of financing a given investment either by taking credit or lending or through placing shares on offer (Wahlen et al, 2010). Financial decisions relating to dividends include deciding whether profits earned by the company are going to be distributed to shareholders as dividends or if the company will hold profits as retained earnings and plough it back to the business. This is important since very high divided might collapse the company through suffocation of its profits and revenues (World Bank., & International Monetary Fund, 2005). Financial assessment In the case of a stock market, financial assessment includes analysis by standard deviation and beta techniques. Before investing, it is appropriate to analyze the performance of the target markets and volatility of stock mutual fund or index in order to forecast and secure returns. Allen & Bruni (1996) state that market vitality is the main reason which triggers need for risk management in financial markets. The performance of stock markets can be evaluated using standard deviation and Beta methods of evaluation (Stock & Watson, 2003). Standard deviation (ơ) Standard deviation estimates risk exposures as a result of changing asset prices and therefore help in determining the most appropriate way of managing investment portfolio. It measures the Volatility of impossible risks. This can be represented mathematically as: Standard deviation (ơ) formula: A bigger standard deviation value indicates that the volatility or unpredictability of future prices is very high. High level of uncertainty makes stock of the market more risk. Investors committing funds in such a market are completely unsure of price movements of stocks and therefore the committed investments will be risky such that, returns might be according to expectations or fail to recover the cost of capital of the investment (Yekim, 2006). Beta (βa ) Beta measures the price volatility of stock in a given market with respect to other markets. Since it measures how returns on assets are sensitive to market returns, it is the correlated relative unpredictability (Carlos, 2007). ra is the rate of return for US portfolio while rb is the rate of return of each of the three countries. Cov(ra,rb) is the covariance between rates of return of US and each of the three countries. If the market has a beta which is less than zero, it means that stocks in the market have a high volatility in price compared to stocks of other markets. It also means that price of these stocks against the direction of the index. Investing in such a market will involve high risks which risk-averse investors might shy away from since they always avoid risks. It is possibly ventured into by the risk aggressive investors and investors who are neither aggressive nor afraid of risks. An example of stocks with such beta is gold (Bala & Premaratne, 2001). Where Beta is more than zero but less than one, it means that, the variation of price for stocks in that market is a bit less than price movements in other stock market but however, the same direction as the stock prices. The prices also experience less fluctuation of the daily operations. This is better for the risk-averse investors since it is less risky, however it has less returns. The purpose for diversification is also less achieved in this case (Jae & Siegel, 2008). Financial assessment using ratios Performance of the company can be reviewed by stakeholders through ratios expressed in percentage, fractions or statements rather than lengthy financial statements. The usefulness of ratio analysis is attained by comparing Company ratios over different financial periods or against same ratios of other Companies in the industry McLaney & Attrill, 2010). Investor ratios and market capitalization determine the positions of the two companies in the market. The ratios include investor’s ratios, profitability ratios, liquidity ratios, asset ratios and leverage rattios. Investor/Market value ratios Earnings per share (EPS) = Profit after interest and Tax/Number of ordinary shares Dividend cover = Profit After interest and tax/Total dividend Increasing EPS ratio shows increasing viability to invest in a company. This results to an upward earning trend. Investors’ ratios indicate is the company stock is in a better position to be purchased. Liquidity ratios include: Current ratios = Current assets/Current liabilities Quick assets ratio = Liquid assets (Current Assets - Inventory)/ Current Liabilities The ratios are indicators of a company’s ability to meet its current obligations using its current assets. Higher liquidity ratios indicate the ability of a company to settle its current obligations using its current assets (Bull, 2008). Leverage ratios include: Debt to equity ratio = Borrowings (long and short-term)/Total Equity (Shareholders + Reserves) Capital gearing ratio = Borrowings (Long-term)/Total Equity (shares + Reserves) + Borrowings (long-term) Times interest covered = Operating profit (Before interest and tax) /Interest charges Increasing debt to equity ratio and capital gearing ratio over years indicate an increasing level of risks in a Company. Bajkowski (1999) states that, increase in vulnerability might lead to bankruptcy since the company will have to settle its debts even at low sales. Higher time interest cover ratios indicate a company’s ability to cover its interest obligations without defaulting. A drop indicates increasing debt burden and reducing ability to pay (Zane et al, 2004). Profitability ratios include: Gross profit margin = Gross profit/sales Revenue * 100% Operating profit margin = Operating profit (Before interest and tax) * 100% Sales revenue Asset cover ratios include: Net asset turn over = Sales Revenue/Total assets less current liabilities Return on Net Assets (RONA) = Net profit Margin (%) * Net Asset turnover Stock/inventory holding period = Stock held/cost of goods sold * 365 days Return on Capital employed = Operating profit (Before interest and tax) * 100% Share capital and reserves pg 88,69 nt.24,23 + Non-current liabilities Returns on shareholders’ Funds = Profit after interest and tax * 100% P61., Share capital and reserve Debtors collection period = debtors/ sales revenue- cash sales * 365 days Reducing ratios for debtor turn over implies an improved efficiency in Company’s debt management. The decreasing ratio indicates that lesser money is being held by debtors and therefore a reducing risk for default by debtors (Lee et al, 2009). Increasing profit over years is an indicator of a better continuity of a Company. A better financial position is an assurance for sustainability and continuing growth. Increasing value of inventory holding period ratio indicates an improving trend in inventory management efficiency (Altman, 1968). However, if this is due to overstocking, the business is susceptible to increased inventory holding costs. This also indicates improved management since sales have also increased over the periods (Watson & Head, 2012). Development of risk management The management of risk involves measurement of the risk and how much appetite the organization has for risk. Risk management has also evolved from only enterprise risk management to management of risks in individual projects and practices. Risk management has developed over a period of time since 1988 to date. More risks are being captured in the finance sector (Cossin & Pirotte, 2001). 1988 Basel 1 1995 Basel 1 other risks 2004 Basel 2 Risk management involves a process of identifying a problem (risk), assessing it and implementation of monitoring measures to control the risk (Ian & Hietala, 2011). Risk assessment Risk management can also involves implementation of an efficient and effective risk assessment criterion employing the viable risk assessment techniques. Risk assessment techniques are identified and implemented depending on the nature of the business, project or the aim of an individual risk manager. The investigated techniques include SWOT analysis, PESTEl analysis, risk ranking, a checklist FMEA, PHA and HazOp, fault tree, common cause analysis, reliability bock diagram, event tree, cost benefit analysis, utility function and business continuity plan (Louis, 2002). SWOT Analysis Risks can be assessed through comparison of main subjects to rival issues. Risks in this case arise from both internal sources and the external environment. according to Nadine & Richter (2009), SWOT is a tool of risk analysis comprising of Strengths and weaknesses that organizations may have which will affect execution of its strategies. It also includes opportunities and threats that the business is exposed to in its environment of operation. Strengths provide a hedge against risks. In case of an organization, its strengths might include appropriate location of the business, unlimited access to financing and offering of unique products and services. The culture and image of a business can also be its strength against its rivals. On the other hand, limited access to finances, lack of uniqueness and originality of products and services are weaknesses that increase probability of risk occurrence. According to Ramos (2000), SWOT and other techniques for financial risk management are better approaches especially in emerging markets. This can be represented qualitatively as: Assessment goal Including goals of the subject Current competition situation Current situation of an entity Current situation in environment Determining strong and weak points Determining chances and risks SWOT analysis assesses future possible risks. According to Nedeljaková(2007), the twofold explanation of a risk is means that, occurrence of a risk communicates either a threat or an opportunity. This is likely to affect the operations of a business or a project under analysis. Once threats are identified, the probability of reducing, avoiding or absorbing them can be devised. Opportunities and threats can be quantified in terms of probability of occurrence or magnitude of the possible loss. For example in the table below: Probability of occurrence of threats Estimation Description Indicators High (probable) Likelihood of occurrence: 1year. -More than 25% occurrence. -Likely occurs several times in(example 8 years). -Recently occurred. Medium (possible) Likely to occur in a 10 year time period or less than 25% chance of occurrence. -Could occur more than once within the time period (for example - ten years). -Could be difficult to control due to some external influences. Is there a history of occurrence? Low (remote) Not likely to occur in a ten year period or less than 2% chance of occurrence Has not occurred. Unlikely to occur. Probability of occurrence of opportunities Estimation Description Indicators High (probable) Favorable outcome is likely to be achieved in one year or better than 75% chance of occurrence. Clear opportunity which can be relied on, with reasonable certainty, to be achieved in the short term based on current management processes. Medium (possible) Reasonable prospects of favorable results in one year of 25% to 75% chance of occurrence. Opportunities which may be achievable but which require careful management. Opportunities which may arise over and above the plan. Low (remote) Some chance of favorable outcome in the medium term or less than 25% enhance of occurrence Possible opportunity which has yet to be fully investigated by management. Opportunity for which the likelihood of success is low on the basis of management resources currently being applied. SWOT analysis can be summarized as shown below: Internal factors Positive Negative Strengths Good reputation High response due to unavailability of red tape and no need for management to approve Professional team Appropriate location High degree of flexibility especially in marketing Partnerships with other businesses globally Lower overheads therefore good value offers to customers Competitiveness Wide range equipment Weakness High prices rules out low income earners Vulnerability to staff turnover Limited to local market with less diversified market Limited staff with shallow skills External factors Opportunities Increasing population that favors expansion of the business customer base Local government is encouraging local business establishment Rapidly growing market Technological diversification Threats Foreign exchange risks Upcoming local and international competitors Changing economic environment PESTLE Analysis Risks involve political factors, economic, social, technological, environmental and legislative factors that affect the organization. According to Rogers (1999), politics can be a motivating factor for risks which would affect the outcome of the investment. The management of organizations and projects are likely to be compromised by political figures who take part in formulating legislation. Expropriation through forced divestment is also an aspect of the government and its political influence on such investments. Analysis of political factors such as terrorism is important during risk assessment. Economic factors include economic players which might have an impact on organization performance. Fluctuations of micro-economic and macro-economic factors such as interest rates, demand, exchange rates, economic growth and purchasing power or money supply is likely to pose risks on business organizations. This effect can either increase or negatively impact profitability. Social aspects also impact organizations performance. The culture of potential customers is likely to affect their consumption of organizations’ products. These also include people’s demographics and structure of their families (Hopkin, p.157, 2012). Technology is another factor under PESTEL which majorly affects organization operations. Change in technology is likely to affect organization competitiveness and its adaptability. The organization’s performance efficiency will also be affected. Environmental factors are aspects in the surrounding of the business. These factors include public perspective of business within the environment that the business is operating in. legislation includes rules and regulations that are likely to affect operation of businesses and their profitability. The analysis can be represented in a diagram and communicated to all departments of the company as shown below Risk ranking (FN diagram) F-N diagram involves estimation of frequency in occurrence represented by F and an estimated number of effected variables represented as N. Risks involve frequency (1/t times an event occurs) and number of effects as a result of the occurrence. The slope of F-N curve is significant in displaying the risk criteria. According to Zsidisin & Ritchie (2008), F-N curves illustrate consequences of risks in terms of frequency data. Risk assessment needs to display historical accounts of events, results from a quantitative risk analysis procedure and standards for adjudging how tolerable the risks are. F-N can be represented mathematical as shown in the formula below: F x N a = k or F = k x N-a Where: F = Cumulative frequency of N or more fatalities N = the number of fatalities a =Aversion factor (often between 1 and 2) k =Constant Risk assessment requires interpretation of variables. In case the F-N curve is less than negative one (x Read More