Concepts of Risk Analysis
Do you remember appearing for exams in school or college? There is one major concern you had. Am I fully prepared for the exam?
What can go wrong in an exam? In the worst-case scenario, the questions you prepared were not set by the examiner. There could also be questions set outside the syllabus!
Just like you were worried about these uncertainties, a company or an investor is worried about a different set of uncertainties. What are these uncertainties, and how do companies and investors deal with them? Let us find out, shall we?
Companies operate in a very dynamic environment that is constantly changing. The major concerns for a company are adverse changes in Government policies, the Companies Act, or the national and international economy. These changes could result in lower profits or losses due to the success or failure of a project.
Investors also need to worry about the company's performance or economic environment. Stock returns vary depending on the company's performance and how it handles negative events like an increase in taxes or a fall in demand.
The tool used by companies or investors to assess the risk in their external environment is called Risk Analysis. It helps companies navigate risks and minimize them. If you are interested in an exciting career in risk analysis, go for a course in risk management.
Importance of Risk Analysis
A financial risk analyst will help boost the revenues of your organization in the following ways:
- Risk Identification: All possible internal and external threats to your company are identified. Some threats that you could face include reputational risks, project risks, technical risks, market risks, and operational risks. To overcome these risks, you would require a SWOT (Strength, Weakness, Opportunity, Threat) analysis.
- Risk Estimation: What is the probability of occurrence of a particular risk in percentage terms? Risk Value = Probability x Cost. For example, if you feel that your landlord might increase the storage space rent by Rs. 5 lacs next year and the probability of this event is 80%, then the risk value is 5 lacs x 80% = Rs. Four lacs.
- Risk Management: Once you know the risk value, you can try to manage the risk. In the above example, you could either try to look for the most cost-effective storage facilities, improve revenues, or reduce costs in other areas.
- Risk Avoidance: All opportunities are screened using a cost-benefit analysis, and if the benefits are greater than the costs, then the investment is worth it. If the costs are greater than the benefits, it is better to ignore such ventures. In the above example, if the cost of finding another storage space is too high, there is no point in looking for one.
- Risk Sharing: You can try a new venture with a business partner to reduce risk or insure your assets through a third-party insurer to minimize losses.
- Risk Acceptance: When there is a possibility of a market crash and a general fall in demand, you need to accept the risk. You can extend higher credit to customers or offer higher discounts to control the revenue loss.
You will learn all this and more in your risk management course.
Examples of Risk Analysis
Let us understand risk analysis through a well-known Indian company, Tata Power. Here are some of the different risks faced by Tata Power and its strategy to mitigate these risks:
|Risk Type||Mitigation Strategy|
|Sectoral Risk - Poor tariff collection in accordance with PPA (Power Purchase Agreement) and customer business health||Diversification of business portfolio and monitoring of tariff collection|
|Technology Risk - Cyber security issues affecting data privacy||Regular testing and modification of cyber security systems and cyber insurance|
|Regulatory Risk - PPA non-renewal and violation of environmental regulations||Use of eco-friendly fly ash in concrete mix and renewal of revised PPA agreement|
|Commercial Risk - Lower margins due to falling wind and solar tariff||Resource optimization and choosing more cost-effective sources of supply|
|Financial Risk - Higher cost of borrowing||Diversifying the lender base and selling non-core assets|
|Business Risk - High thermal plant fuel cost||Improving operational efficiency and exploring cheaper fuel alternatives|
|External Environment Risk - Climate-induced risks to production units in coastal areas and restrictions on carbon emissions||Greater focus on renewable energy to lower carbon emissions and a disaster management plan for production units in coastal areas|
In the next section, we will try to understand risk analysis in more detail.
Understanding Risk Analysis
You can estimate risk through a financial statement analysis. How do you analyze a financial statement, and how does it help to estimate risk?
The key financial statements vital for risk analysis include the Cash Flow Statement, the Income Statement, and the Balance Sheet. While doing a risk management certification, you will understand how these financial statements help to identify and mitigate risk.
Here is a brief description of the key financial statements:
Cash flow Statement:
The difference between the revenues and expenses generated by a company determines its cash flow. The revenues are generated from three areas:
- Operating Activities - Revenues from operations are included under this heading
- Investing Activities - The income generated from investments is stated here
- Financing Activities - Income from equity and debt financing are included here
While doing a course in risk management, you need to know the details of the income and expenditure of a business. The income statement contains critical information like Gross Profit, Operating Profit, and Net Profit. The following table highlights the relationship between these three concepts:
|(Less) Direct Costs||XXX|
|(Less) Indirect Costs|
The Balance Sheet helps you determine the value of a company. There are three components of a Balance Sheet. They are:
- Assets: The Fixed Assets (long-term) and Current Assets (short-term) come under this heading. Current assets include accounts receivable (debtors) of the company
- Current Liabilities: This includes accounts payable (creditors) of the company
- Shareholder's Equity: The difference between Assets and Current Liabilities includes Shareholder's Equity. A surplus of Income over Expenditure is added here every year.
The Shareholder's Equity is an important tool for measuring a company's book value, and it goes up or down depending on the company's performance.
Financial statement analysis comprises analyzing the following ratios under each heading:
- Cash Flow Statement: EBITDA (Earnings before interest, taxes, depreciation, and amortization)
- Income Statement: Interest Coverage Ratio, Net Profit Margin, Operating Profit Margin, and Gross Profit Margin
- Balance Sheet: Debt to Equity, Receivables Turnover, Quick Ratio (cash and liquid assets to accounts receivables), and Asset Turnover
When creating a budget for your company after financial analysis, you need to factor in the different risks that could affect your performance. A financial risk analyst will help you create an accurate budget by considering the economic and regulatory risks. Revenues will be stated after accounting for these risks.
Here are some risks you need to consider:
- Credit Risk: If accounts receivables default in payment, provisions need to be made.
- Currency Risk: If you are an exporter, currency risks are identified and hedged through derivatives.
- Market Risk: A sudden fall in demand due to a market crash needs to be protected through reserves.
Now that we know what risk analysis is all about let us understand the different types of risk analysis.
What are the Different Types of Risk Analysis?
Two types of risks are taught in a risk management course.
Quantitative Risk Analysis
As the name suggests, quantitative risk analysis is based on numbers and uses a statistical model to provide the probability of different outcomes. Assumptions are entered into the model as input, and you get a range of outputs.
A financial risk analyst analyzes the output using graphs and scenario analysis. The risk mitigation strategies are decided based on the analysis of the output.
A popular statistical method, Monte Carlo Simulation, creates a probability distribution of all the different outputs. The mean output can then be calculated, and then the standard deviation from the mean is calculated. The higher the standard deviation, the riskier the decision.
The scenario analysis gives the risk manager a clear insight into the worst, middle, and best outcomes. An exporter can analyze the impact of exchange rate fluctuations using this model. A portfolio manager can check the variance of the portfolio by assigning different values to different asset classes.
Unlike quantitative risk assessment, the second method does not use numbers for risk analysis.
Qualitative Risk Analysis
The second method, quality risk management, uses a more theoretical approach to risk analysis. Qualitative risk analysis prepares a list of uncertainties and the risk mitigation strategy.
Qualitative risk analysis is used in project risk management. There are two ways in which opportunities and risks in a project are ranked. They are:
- Evaluating Occurrence Probability (P): This measures the probability of an event and varies between a 1 and 99% range.
- Evaluating Impact Severity (I): The impact levels are mapped along with the severity of each on the company's performance.
The criticality of each risk level = P x I. The project manager needs to address the critical issues on a priority basis since the project's success depends on it.
SWOT analysis, decision matrix, and cause and effect diagrams are qualitative risk tools.
Where Do You Apply Qualitative and Quantitative Risk Analysis?
Qualitative Risk Analysis is used in the following situations:
- At the start of a project
- Since the process is quick and cheap, it can be applied at any stage of the project
- If a new risk is identified or the nature of the existing risk changes, this model yields the best results
Quantitative Risk Analysis can be applied in these situations:
- When you have large quantities of data for the risk
- Qualitative Analysis has been applied, but the results require validation
- Since it is time-consuming, it should be used only when the law requires it or the project's stakeholders want it.
We next discuss the limitations of risk analysis.
Limitations of Risk Analysis
Though risk analysis has its benefits, this method has several limitations. They are:
- Based on Probability: You do not know the exact risk you are facing. All you know are the different kinds of losses you may face
- No Standard Method: You cannot confidently use one method to calculate risk
- Not applicable for Extreme Situations: Risk analysis assumes a normal distribution of risk but does not account for extreme cases like the 2008 financial crisis, where investors lost billions of dollars globally.
In the next section, we will find the best risk management courses for you.
The global risk analytics market is expected to grow from $39.3 billion in 2022 to $70.5 billion in 2027, an annualized growth of 12.4%! To be a part of this lucrative industry, you need to undergo training through top-quality risk management courses.
You can get risk management certification at leading online learning platforms like Hero Vired. Here are some of the highlights of this program:
- Course taught by leading industry faculty.
- Hands-on learning through real-life projects.
- Professional Certificate from Columbia University.
- 70 to 90% live online instructor-led classes.
- Six months course with a 3-month capstone project.
- Learn the valuation of companies and investments.
- Detailed coverage of Modern finance and risk management.
Enroll today and begin your career in the profitable risk analysis industry.