RISKS OF FINANCE

1.0 INTRODUCTION

To function properly in business, you should consider the risk taken; especially in the sourcing and usage of fund.
In this unit, you would be led to the investor’s dilemma, especially in the developing economy like Nigeria, where risk taking is much dreaded and one has to “look before one leaps” in financial venture.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

1. discuss the risks of finance 
2.  state category of risks in finance 
3. Identify how to avoid finance risks. 

3.0 MAIN CONTENT

3.1 Investor’s Dilemma

If the investor believes that there is some chance, however small, that in the long run he may earn a small return (profit), he would extra effort than he could obtain on a riskless investment. He will not invest unless he can expect a higher return if the investment does succeed. Though in
the course of event, he will not necessarily expect this higher return to become available at once.
This allowance for risk, in greater or less degree, is made whenever the yield of the investment is anywhere dependent on the satisfactory result of the undertaking of work for which the full fruits are reaped only after a delay.
It is pertinent to note that there can never be a certainty that the fruits, when reaped would be commensurate with the cost of resources (labour, capital etc) expended in the production/marketing.
Hence, there is always some chance that part or all of the resources employed may prove to have been wasted.
The risk that threatens the complete or partial loss of the postponed fruits of effort can be classified under four main headings:

1.  Physical risks 
2. Technical risks 
3.  Economic risks 
4. Political risks 

3.2 Physical Risks and Finance

These are risks that some accident may destroy or spoil some physical goods created by the work financed.
For example:

1.  A stock of food may go bad or be eaten up by insects or animals  A house (premises) may be destroyed by fire 
2.  A ship may be wrecked or sunk. 

Dangers from fire, flood, storm, theft etc. have always threatened and still threaten the benefit of the fruits of business enterprise.

3.3 Technical Risks and Finance

These are those risks that arise from the fact that the producer’s skill or that of the subordinates may not be up to the expected level for the plan, hence it may fall short of achieving the intention. If at all it is achieved, it may fall below the standard; i.e. the end-product, at disposal may consume, in its construction, more resources than permitted in making the plans.

For example, a farm entrepreneur in a new environment may try to grow crops unsuited to the soil or climate. A new technical process, successful in the laboratory or in small-scale plant, may encounter unforeseen difficulties when tried in large-scale production. Wherever experience of the exact process is lacking, whether because the process itself is only newly developed or because of the lack of experience of the people using it, a high degree of technical risk is always present. This is one of the reasons why the early stage of enterprise venturing into new areas of producing goods/services, using newly processes are nearly always less satisfactory than anticipated.

Experience (know-how) gained by the organization of its particular technical process which often constitutes its most valuable possession. Thus, unforeseen technical risk in finance renders the whole months of intensive work completely wasteful; except for the obtaining of valuable experience.

3.4 Economic Risks and Finance

This category of risks is usually the greatest and closely related to finance. They remain; even though the physical object created suffer no unexpected damage. It is found possible to construct these physical objects with the resources assumed to be available. There are four main kinds of this risk:

1. The risk of an inadequate supply of the resources needed to make the product planned so that it costs more to make than had been expected or even cannot be made at all; and 
2. The risk of fall in demand for the product once it has been made. 
3. The risk of a failure of the demand for a product is increased when that product is itself highly durable, for them to the other risk. 
4. The risk that potential purchasers may be prevented from buying by a shortage of finance. 

3.5 Political Risk and Finance

These are risks of losses as the result of unforeseen intervention by governments. These risks may particularly affect the enterprise operating in or exporting to, a foreign country, where government laws discriminate. This may have untold frustration in the quest for achievement of the expected return on capital investment. Example includes Rent Act, which can affect the status of workers who are tenants if it is not favourable; corporate tax can affect the profit margin of an enterprise and this may in turn have effect on the finances of the organization.

SELF ASSESSMENT EXERCISE 1

List the different types of risk associated with the finance of an enterprise.

3.6 Avoidance of Risk

There are three ways of avoiding or reducing risk. These are as follows:

1. Appropriate measures involving additional expenditure; 
2. Turn into regular costs by pooling them with large numbers of similar risks; and 
3.  Combing them with other risks operating in the opposite direction. 

Almost every kind of risk can be reduced, to some extent, by increasing expenditure on precautions as follows:

1. A building can be made more resistant to fire if more fund is expended on it to add value to it. 
2. The risk of financial failure of a new method of production can be reduced at the cost of increased expenditure of time and money; if a thorough testing in a small-scale plant is made before being introduced into large-scale production (project). 
3.  The risk of production being held up for lack of an important component can be removed and the cost of an immediate loss of output avoided; if adequate reserve stocks are built up. 
4.  Even the risk of miscalculating consumers’ demand can be reduced by expenditure on market research, advertisement and sales promotion. 

The great difficulty is usually to determine how large an increase in costs is justified in order to achieve an uncertain degree of reduction in an uncertain risk.

SELF ASSESSMENT EXERCISE 2

Name ways of avoiding risk in a business concern.

3.7 Distribution of Risks

After eliminating all the risks which can be reduced by taking precautions, pooled by insurance or offset by hedging (the term used for reducing risk by using derivatives – debt capacity enhancement, increased focus on operations and isolating managerial performance which we tried to explain earlier).

There remain a very large number of risks that must be borne by whoever provides the finance for a productive operation. It is with these various methods of sharing such risks among various classes of providers of capital that this unit is mainly concerned with.
The simplest form of finance is where the whole of finance required by a particular enterprise is provided by an Entrepreneur (a single person). In this business, the person pays all expenses, takes all receipts and makes the whole of any profit or loss which results from the activities of the business. When the business requires more assets than he can afford to provide personally (expansion) then, there arises the problem of how to distribute the risk inherent in the business. Hence, different contributors to the finance of the business will be required to share the risk as shareholders.

The number of possible ways in which the risks and profits can be shared between the different people who jointly contribute to the finance of a business is also infinite. The following ways are frequently adopted.

1.  A full share of all risk and profits. 
2. A prior claim on any profits the enterprise can earn up to a certain limited amount, with or without some share in the remainder. 
3.  A loan of money on payment of a fixed amount of interest which must be paid whether the concern is earning a profit or not.
4.  The renting of land or other durable good is return for fixed money (rent), payable whether or not the enterprise is able to earn a profit (leasing). 

Partnership and Limited Liability Company are two main institutional forms under which people join together on equal terms to provide the finance needed for an enterprise, sharing fully in both risks and profits.

SELF ASSESSMENT EXERCISE 3

Name two structures of sharing finance risks.

4.0 CONCLUSION

The categories of risk of finance in a business organization were identified and discussed. The manners or ways on how to minimize risks among investors were suggested as well as the means of distributing the risk.

5.0 SUMMARY

In this unit, attempts have been made to discuss risk of finance and business, types of risk (physical, technical, economic, political), the avoidance and distribution of risk.

6.0 TUTOR-MARKED ASSIGNMENT

1. Discuss the finance dilemma of an entrepreneur. 
2.  Explain how finance risks affect technical risk