Financing risks in theory and practice
When deciding on raising funds, the financial director should take into account what the bulk of the company’s fixed costs are connected with and what is the situation with interest payments. Otherwise, there is a risk of seriously undermining the financial stability and profitability of the business.
Financing structure issues are important for any manager with the right to make decisions on attracting loans or investments. They are one of the most difficult. Should I use borrowed capital or limit my own? If used, will a bank or private investor be a creditor? If this is a private investor, what conditions to offer him? Etc.
The situation is aggravated by the fact that in case of raising money, the company must be “shown face”. This is an extremely controversial matter. If the picture turns out to be too good, it would be logical to require a lower percentage from the investor (the “risk premium” is reduced), and this may scare him away. If the picture is “not very”, then things may not reach the discussion of the conditions at all.
According to the theory, business risk can be assessed in terms of an asset (production risk) or liability (financial risk). Quantitatively, risk is measured by the so-called leverage, or leverage (from the English leverage – “leverage”). This is an indicator that takes into account the sensitivity of profit to fluctuations in income (production leverage) or interest payments (financial leverage). The theory does not give a single indicator that could reflect both types of risk collectively. However, it is believed that high financial risk should not be combined with high production risk. What is behind this statement and how achievable is it? Types of business: rules and exceptions
Leverage is easiest to evaluate by the share of fixed costs in the total cost of the enterprise. The larger it is, the higher the production risk: if you want it, you don’t want it, you need to cover fixed costs. Of course, revenue can experience such strong seasonal fluctuations that during a recession, revenues are lower than even fixed costs. In this case, it is necessary to form an appropriate fund that would counter such an adverse effect. This requirement is usually fulfilled by those companies that are used to regular sales downturns and never – those whom this surprise overtook for the first time.
Which companies are characterized by a high level of fixed costs? The easiest way to determine this, based on the classification of enterprises according to the criterion of the most important factor of production. Then it is easy to distinguish the following types of business:
Capital-intensive. For him, the main factor is non-current assets: land, buildings and structures, equipment. These are large metallurgical and shipbuilding plants, agricultural production, transport, construction. The main share of the expenses of enterprises in these industries is accounted for by funds: depreciation plus expenses to maintain their technical condition. And almost all of these costs are ongoing.
Material intensive. This business depends on the procurement of raw materials, materials and components. The classics of the genre are trade, both wholesale and retail. The main share of expenses in these sectors is accounted for by raw materials, materials and components. Therefore, the financial result is sensitive to extremely weak fluctuations in the trade margin.
So, the director of a wholesale company selling building materials, the question arose: why do they sell much more products in the summer, and the profit remains the same, even slightly decreases? The answer was simple. In the summer, the proportion of large orders for which it is customary to give discounts increases. As a result of their provision, the share of direct expenses increased from the usual 77.5 to 80.5 percent and “ate” 60 percent of the profit.
The flip side of profit sensitivity is the ability to reduce purchasing costs during periods of decline in sales. So the production risk for this area is not too terrible.
Labour intensive. The main factor of this business is the staff, and the main expenses are wages. This includes a significant part of the service sector: consulting, education, and partly healthcare. Here, production risk is primarily due to the payment of wages. The management of the company can theoretically tie it to the results of operations, but it risks losing employees. The level of fixed costs here is lower than in capital-intensive industries, and there is more room for maneuver: you can reduce staff, send them on vacation, and cut salaries. However, the production risk is still quite high.
There are also industries whose enterprises either do not have a pronounced type, or may be of different types, depending on the circumstances. A good illustration is catering. In an inexpensive cafe, the share of spending on funds, raw materials and salaries can be approximately equal. At the same time, a fashionable restaurant will almost certainly turn out to be capital-intensive, and a factory canteen – a material-intensive enterprise. Own or borrowed?