Risk is there in every business. The greater the size of the organisation the greater is the risk associated with it. Here Risk Analysis comes into the picture.
With huge risks also comes the great chances of earning profits. Therefore, profits are the reward for taking a risk.
But for earning huge profits we cannot blindly venture in risky projects. So we need to predict and analyze the number of risks which are associated with our business. Here the concept of risk analysis comes into play.
In this post, we are going to learn about the various techniques and ways of conducting risk analysis but before that let us look at what exactly risk analysis is.
Risk analysis is known to be a process in which a firm tries to identify and analyze potential risks which could have a negative impact on our key business areas and projects.
Types of Risk
These type of risk are due to external factors of the business and these affect the entire industry, not any particular business.
They are uncontrollable and unavoidable and are associated with macro factors of the industry like economic, political, social etc.
These are three types of systematic risk:
Market risk: these risks are a cause of alternating forces of supply and demand. It means that the value of the investment changes due to changes in market factors. These factors can be both tangible or intangible.
Interest risk: these types of risk are associated with fluctuations in the interest rate in the market. Due to the presence of these risks, the value of the investment affects because of the fluctuation in the interest rate. It becomes a macro factor as any changes in monitory policy by the government will affect the entire industry.
Purchasing power risk: the major causes of these risk is the amount of inflation in the market. Due to inflation, there is a significant decrease in the purchasing power of consumers. The low purchasing power will result in low demand.
These are the risks which are specific to a business and are caused by the internal factors to the business and hence are to be managed by the business itself. These can be due to factors like poor operation system, incompetent staff etc.
These are basically of two types:
- Business risk: Business risk can be due to both internal risk and external risk.
- Internal risk– the risk associated with the internal factors of the business, the most common factor is poor operational efficiency.
- External risk– the risk associated with the external factors to business, these are the macro factors external to the business.
- Financial risk: risks which are related to the financial and capital structure of the company are called financial risks. These can be further classified as currency risk, credit risk, liquidity risk.
Also Read: Fundamental Analysis
Causes of Risk
- Political and legal factors: these refer to the risk caused by changes in government policies
- Nature of the industry: risk also depends upon the nature of the industry in which the business operates. Some industries have high risk while others have a comparatively lower risk
- Level of investment: another cause of risk is the level of investment. The greater the investment the greater is the amount of risk.
- Tenure of the investment: risk varies with the tenure for which a sum of money is invested. Long term investment generally have high-risk levels as compared to short term investments
- Timing of decisions: decisions taken on wrong timings can cause risk
- Quality of decisions: the quality of decisions is also a cause of risk
Statistical Techniques for Risk Analysis
Probability of occurrence of all events always lies between zero and one. The probability technique is fundamental in risk analysis. It works on the principle of the occurrence of the events.
If any event is not likely to occur then the probability is 0 and if the event is likely to occur in future then its probability is occurrence is termed 1. This technique works on the probability principle. Risk is estimated on the basis of the occurrence of events.
Expected Net Present Value
The expected net present value is by multiplying the monetary values of an event by probability of their occurrence. This is carried after assigning a probability to future cash flows.
The concept of standard deviation is used in risk analysis because of the fact that the assignment of probabilities and the calculation of the expected net present value do not provide a great insight towards risk analysis.
When the projects which are under consideration have the same amount of cash outlay standard deviation is an absolute measure to consider.
Coefficient of Variation
For the situations in which the projects under consideration have different cash outlays then the correct choice would be to choose the coefficient of variation because of the fact that it is a relative measure.
The formula for Coefficient of variation is:
Expected value/ standard deviation.
Also Read- Market and Demand Analysis in Business
Forecasting cash flows prove to be essential while evaluating capital budgeting project. This forecast is highly dependant on the forecast of sales and costs. There is a huge amount of uncertainty in the behaviour of all these variables.
Here is where sensitivity analysis comes into the picture as it helps in estimating the amount of sensitivity of all these variables associated with the project. The more is the amount of sensitivity the more critical the variable is.
This technique of risk analysis helps us to overcome the shortcomings of the sensitivity analysis. The shortcoming is that in sensitivity analysis only one variable is measured at a point of time. But what then if the various variables associated are somehow interrelated to each other. Then sensitivity analysis fails.
In this case scenario analysis plays an important role. In this, we look at probable scenarios in which each scenario consists of a combination of the associated variables. Lets quickly have a look at the procedure:
- Select the variables and make different scenarios
- Estimate values for each variable in each scenario
- Calculate the net present value under each scenario
In this analysis, the project manager wants to know the point below which the project will not lose money. This point is the break-even point. This finding of the break-even point is the break-even analysis. It can show in both accounting terms and financial terms.
Decision Tree Approach
A decision tree approach is the one in which the estimation of cash flows is done under various management options. It is a kind of a graphical representation of present decisions with future probable events and decisions.
Under the decision tree approach, the sequence of the events is shown in a format similar to the branches of a tree. The steps involved in this technique are:
- Defining the proposal by the construction of the decision tree
- Identification of various alternatives
- The decision tree showing different alternatives through its branches is laid down. The cash flow estimates and probabilities of each branch are made.
- Different branches are then calculated and it shows which of the branch alternative is more suitable amongst others.
Risk is present everywhere and in this entire world, there is no such business which is risk proof. The amount of risk may vary but the risk is there. So as a business we can only estimate the amount of risk and try to tackle it. Different types of risks and techniques to analyze such risks are mentioned above in the post to help you out with risk analysis.
Stay with us to get more such amazing stuff from our side. We will be meeting soon. Till then have a look at some FAQs;
Frequently Asked Questions
Risk analysis proves to be important because of huge and various risks present in the market and to analyze these risks beforehand can save us from huge losses and also we can look for more opportunities
Risk analysis is not mandatory but it is advisable to perform risk analysis.
Capital budgeting requires estimation for huge investments and with such huge investments the risk is great and hence risk analysis is advisable.
Yes, it is an ongoing process as risks can come any time and in any form.