Risks faced by shareholders in a business
Corporate musings by Ravi Mahendra
The basic idea behind finance is that all investments, unless they are government securities, tend to have an element of risk attached to them. Whenever there is risk, there is a need to earn an extra amount of return in order to compensate for that risk which has been taken. In the case of small investors, to whom I address these articles, you may be risk averse and unwilling to undertake certain investments if you were adequately aware of the risks involved.

Risks faced by businesses can mainly be categorised into business risk and financial risk whereas others such as political risk, economic risk, and management risk may also be considered.

Business Risk
Not all businesses are similar. Presently I manage a school, whereas my previous employment was related to venture capital and I find that the level and type of risks faced by both sectors are in fact, incomparable. I am sure it would be obvious to everyone that risks vary depending on the line of business selected. The hotels in Sri Lanka face more risk than private hospitals, because the hotel industry is dependant on tourist arrivals, which is influenced by various local as well as foreign, factors most of which are beyond the control of the management.

Financial Risk
This risk depends on how a business is funded in the long run. There are two types of funding available to a business, which are shareholders funds (equity) or loan funds (debt). Equity leads to ownership and profit sharing, whereas debt leads to repayment of interest and capital. The Debt to Equity ratio is known as Gearing and as this increases, the financial risk faced by the shareholders increases as well.

A highly geared company will be very vulnerable to bankruptcy or failure if its profits and cash flows dip significantly since it will not be able to pay interest and capital. The risks faced by highly geared company shareholders are therefore high when compared to their counterparts in low-geared companies.

Political risks
Even though political forces affect all businesses, some are more vulnerable than others. The hotels in Sri Lanka are affected by local as well as international political and terrorist activities, whereas the apparel sector is affected by the political forces in the US and Europe.

Economic Risks
Different industries can get affected by economic factors in different forms. Firms which provide financial services are severely affected by an economic downturn in a similar fashion to car dealers in Sri Lanka. The export firms such as apparel and tea are dependant on foreign economies. Importers are affected by the risk of exchange rate fluctuations.

Management risks
Increasingly, the risk faced by most businesses is from the management teams themselves since they are in charge of managing the business, and can sometimes be driven by other agendas.

The latest news to hit the headlines was of Parmalat, the Italian Dairy giant whose founder himself has admitted to committing fraud. Be vigilant about where you put your money, because the wrong people may be managing it, or in worse cases, misusing it.

Message to the investor
The investment which you are making may in fact have more risks than you foresee. Ensure that these are risks that you are willing to take and if you take them you are adequately rewarded. As the English proverb goes "Still waters may in fact run deep."

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