How does risk affect a company’s financial decisions? - GRM Institute

How does risk affect a company’s financial decisions?

How does risk affect a company’s financial decisions?

 

The dependency on risk identification, mitigation, and management has increased in both financial institutions and corporates. The main reason for this is the changing economic landscape.

Financial decision plays a very crucial to know how, when, and where one should be acquiring a business fund.

In any organization, the maximization of the profit happens when the market estimates of the organization increases which largely depends on the financial decisions.

 

There are generally four different kinds of financial decisions:

 

  • Capital Budgeting Decision:

Capital budgeting decision helps the financial manager to analyze the size of the firm and to take decisions like where the amount is to be invested and how to invest it. It’s basically a process of planning and managing the firm’s long term investment. It aids in identifying the profitable investment opportunity for the company by assessing the size, risk in future cash flows (inflows and outflows), and timings. An ineffective capital budgeting decision gives rise to the operating and business risk of the company.

In capital budgeting decisions, the guru mantra i.e. High Risk generates high returns and vice versa generally holds true. But from a finance manager’s perspective, he generally prefers to minimize the risk by maximizing the returns in any given scenario. Hence, the concept of risk-return trade-off exists in it. For example, any company investing in small machinery can be less risky than an investment in larger ones. Which in turn has cons of generating low returns from it.

 

  • Capital Structure Decision:

It is rightly said, ‘the most favorable capital structure for any organization is one which minimizes the overall cost of capital and maximizes the firm’s value’.

What does the firm’s capital structure mean?

Capital structure means an appropriate mixture of long-term debt and equity. It helps the finance manager to decide the sources from where the funds need to be raised.

For the long-term benefits of the organization, there has to be the appropriate combination of both debt and equity. It helps to mitigate a company’s financial risk.

Generally, the debt for any organization is cheaper than equity and there are various reasons like the interest is tax-deductible for the company and since the debt is generally before the equity, it becomes an investor’s choice. Having high debt and low equity is also not beneficial for the company as the company needs to pay even if they incur heavy loss. Hence the risk-return trade-off is helpful in understanding and deciding the optimal finance mix.

For any organization which relies on debt capital, which means lower cost of capital and higher returns with high risk. Whereas in the case of equity there is a higher cost of capital but lower returns and lower risk.

 

  • Dividend Decision:

After payment of tax, whether the profit of the business should be retained or distributed amongst the shareholders or both. Dividend decision helps to answer these questions.

It is very important for a company to strike a balance between dividends and retained earnings to meet the needs of investors. A low divi­dend payout is generally riskier but has a high return and vice versa. Hence organizations rely on risk-return trade-offs.

 

  • Working Capital Management Decision:

Working capital management decision helps the financial manager to know the possible sources of short-term funds and the proportion in which these funds need to be raised from the investors. It also helps to know the appropriate level of cash and inventory. Basically, Working capital management is all about managing a firm’s short term funds.

It is essential for the finance manager to have an optimal level of working capital management. Working capital impacts the liquidity and profitability of the firm. High liquidity means more current assets i.e decrease in profit. This will reduce the risk of default in meeting short-term obligations in the organization.

 

Beauty in this financial decision lies in its interdependency. While calculating capital budgeting decisions we rely on the calculation of the present value of cost and benefits, which is highly dependent on the discount rate. Whereas, the result of capital structure i.e cost of capital has its usage as the discount rate in capital budgeting decision.

Hence we can say that there is interdependency in both investment and financial decisions. Similarly, due to huge investment in the capital budget the operating risk increases which leads to lower debt capital and reduces the financial risk. Hence it is very important for an organization to have a sound financial decision in order to reduce risks.

 

By Sharvari Saraf

PGDRM Batch Jan’20–21

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