This lecture defines and categorizes various types of business risks, emphasizing the importance of understanding and managing them to balance potential returns with acceptable levels of exposure.
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this is a lecture from open tuition to
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open tuition comp we now move away from
the section of the syllabus that dealt
with strategy
and on to the section of the Stratus
syllabus which deals with risk and first
of all we need some definitions risk is
a condition in which there is a
quantifiable this version of the
possible outcomes so quantifiable in
other words if you're dealing with risk
strictly speaking you can attach
probabilities to what's going to happen
so if you're developing a new product
the new product could either sell well
it could sell badly if you can say well
I think it's gonna sell well excuse me
with a probability 0.7 and bad with the
probability 0.3 then you are in the area
of risk so quantifiable dispersion and
of course there are different possible
outcomes success/failure high cost low
uncertainty is really were you don't
have the quantifiable probability
statistics you know the things could go
bad or could go well but we haven't got
any information about the relative
likelihood of them going bad or going
well we're working much more on the dark
insurance company's work with risk so
insurance companies have all sorts of
statistics about the chance of a 30 year
old male having a car accident compared
maybe to the the chance over a 40 year
old female and and so on and of course
they can also based on your driving
record and so on they have a risk figure
in mind which is going to determine your
Premium so may Life Assurance they have
all sorts of statistics about the if
somebody is fifty years old the
probability that they're going to be
alive and say 25 years or 30 years or 35
years and it depends on male/female it
depends on baby
previous health issues that they would
have it depends on where they live and
so on but they've got this really
detailed information about the
probabilities of survival and again they
can use that to determine life insurance
premiums or pension annuities and the
like when we come to really consider the
the almost the impact of risk it is
really good
got two components to it there is a
probability that the event will happen
and then there is the consequence or the
consequences that take place if it does
happen so the two kind of areas we'll be
looking at there or we can look at is
you could have an event which is very
unlikely and if the consequences were
quite severe you might decide to put up
with it
so you know when you're crossing a road
there is a chance that you will be
knocked down and the consequences are
very severe but on your own mind you're
doing a little kind of calculation and
say well I could be killed crossing the
road but actually the probability of me
being killed crossing road is terribly
small and we clean it would cross the
road multiple times a day or there could
be a high probability of something
happening and the consequences are
relatively small so high probability
maybe of something happening is that you
know when you're washing up a cup of
something maybe you drop it or you chip
it on the tap but by and large it's a
fairly trivial event and we just don't
kind of worry about
that where we get particularly worried
as well as high probability now high
consequences so we know there's a high
probability of the event occurring and
in particular the consequences are going
to be very bad there may become maybe
quite worried about that so many people
will for example maybe not undertake any
sort of adventure sports or dangerous
sports because you know if I begin that
they in their mind because we've got
different perceptions of risk if I begin
skydiving or rock climbing or something
there is a substantial risk I'm going to
fall and if I do fall then the
consequences could be severe and so they
avoided other people I've got quite a
different perception of what the risks
might do and of course and of course
something is very important and risk is
you can often control it so in rock
climbing you essentially control the
risk or can control it by using ropes
and alike and you bring the risk down to
maybe something which is acceptable some
more little bits of the terminology
downside risk is a possibility of a loss
and and if there is no possibility of
any gain and there's only loss the
religious pure risk so pure risk is near
coming from a fire so fire in your home
of fire offers no good things are going
to come from ideas pure risk it is
certainly downside risk another example
would be a virus that could be a virus
in your body if I'm talking about a
computer virus there's really no good
news and by getting a computer virus and
that risk is pure risk it is all
downside absurd risk is a possibility of
a gain and of course the the upside risk
the possibility of the gain
is perhaps when you get a new product we
launched a new product with the hope for
that it will sell well and make us again
because we're not certain and by far the
most common form of risk is respective
to the risk where things can go both ways
ways
so if invest in shares they could go up
and go down if you change money into
foreign currency it can get more
valuable less valuable if you launch a
new product it could go well it could go
badly happen and so on so most risk will
come across is going to be speculative
risk and we talk about risk we tend to
think of any downside risk we we focus
on on the bad things but strictly
speaking risk is a usually a two-way street
street
risk will take into account also the
possibility of things going well what
we're doing in business or almost any
activity is really balancing risk and I
suppose return if in business certainly
you take no risks whatsoever you don't
develop any new products you don't try
to go into any new countries and so on
then you're not going to make much of a
profit if you're not going to take any
risk whatsoever but anything you can do
commercially is maybe put your money in
a very safe bank account and just earn
very small amounts of interest but most
companies want to develop products
develop markets and gain customers and
so on and as they're gonna do that they
have to incur some risk you have to take
the risk of deciding maybe to open in
America it might not work but if it does
work then of course we've got a vast
population who could provide new
customers to us
however this always requirement and as
almost an unnatural activity of
entrepreneurs to want to take risk has
to be kept within bounds a sturdy
conformance that we don't want the
company to be taking if you like
outrageous risks undertaking projects
which if they fail could lead to the end
of the company so we have this balance
between what's called performance taking
a risk and I hope we're going to get
better province bright profits and
conformance conformance that we can of
control people's risk taking that we
mitigated that we stopped spending more
money and a project if it seems to be
irredeemably bad and so on and their
compliance with the rules and
regulations to limit the risk is
necessary but generally speaking higher
risks are going to be needed to produce
higher returns and all of the argument
is about how much higher shoot those
risks be and there is no single answer
to that what we can do here is look at
the the risks you might undertake look
at the competitive advantages return the
possibility of increased profits if you
like and some things are routine we're
not going to get much extra profit but
it's not gonna be much extra risk so it
could be signing up a a small new
customer and giving them a small credit
limit so not going to buy very much from
us at the start there's a risk that they
don't pay us but of course if we put a
credit limit on that
that's the compliance bit of it then the
risk of they go bad is low and even if
they do go bad we're not going to lose
it that much if it's high and high we're
going to avoid it a big one of it's a
high risk but low return
then it's obviously something to avoid
so if we were thinking maybe we should
develop a new product but actually the
market for that new product is very
small why would we want to take this
high risk that the development of the
problem might fail if at the end of the
day it's only gonna sell you know a few
hundred units a year and the extra
profit is going to be trivial
you'll probably decide not to even start
developing that product if we're high
and high so maybe developing a new
product but now if it comes off there's
gonna be a vast new market and a really
high return or increase in our
competitive advantage that's what we
need to look at Caffe that's where we
really come up against the the balancing
which is going on here high risk we
spend a lot of money up front but you
know we might have to write it off
because it doesn't work but in the other
hand there are perhaps riches at the end
of the day and this is a sort of thing
where you know that there are certain
strategies that maybe we say well after
year let's see how the project is going
if it seems to be on stream if the costs
seem to be controlled till it seems to
be technically feasible well go on with
it but if at the end of the year when we
review the project then maybe that's
when we decide to pull the rug and not
to do anything more with it this is
great this is a kind of no-brainer
there's low risk and the possibility of
high return then we're going to go for
that so if for example a distributor in
a foreign country said look our
population really wants to your product
why don't you export your product to me
all you have to do sell it to me I would
look after all the distribution and
marketing in my own country because I
know about that and then you're into
probably this this come on almost golden
quadrant here there's relatively low
risk you could maybe take out credit
insurance you can make
have you even paid in advance by this
overseas agent so you're not exposed
very much to risk but the overseas
market particularly when dealt with by
this agent who knows what they're doing
it could really bring on very very high
extra returns extra profits and you
definitely go for that the risks are
categorized into any form and types the
first two are going to be strategic and
operational risks and the first one
we've got here are strategic risks and I
think of what we've always said about
strategy it's kind of long term and the
street a strategic risk is really going
wrong in the long term making sort of
rather fundamental errors perhaps in our
decisions or rather fundamental things
happening the market had an example
maybe or face
company which has suffered from a
strategic risk what we have the company
we mentioned right at the start of the
the kind of lectures Nokia so Nokia did
very well but then essentially the long
term technology changed people went for
smartphones and and so on and no Korea
didn't alter its position in the market
quickly enough a Kodak was another one
of a strategic risk suddenly the product
that was our breadwinner and a very
profitable product nobody wanted it
anymore what can cause it it can be the
Lance and outdated technology maybe like
Kodak competitor action maybe a
competitor's suddenly develops a better
product and we're kind of left standing
reliance on a declining market or maybe
we have too much of our operations in a
declining country country which is gone
into economic recession and so on
and really eats into our profitability
reputational risk over perhaps a number
of years has been a few scandals and
people can look at us and say well it is
that wrong in that year the next year
that did that wrong what else is is kind
of kind of skeleton to come out of the
closet and so on I just don't trust
those people anymore and I suppose we
could think maybe a Volkswagen fantastic
reputation and then there was the
scandal about Miss reporting emissions
from particular diesel cars but also
other cars and suddenly you know they
were at great reputational risk they
seem to have done okay but it was very
expensive fallen how perhaps financial
risks you borrow too much your interest
burden is too great your profits fall a
little bit and suddenly you can't pay
operational risks are much shorter term
risks they're almost day-to-day things
that go wrong so examples could be human error
error
some of the pressing the wrong button on
a machine or deleting important files in
the computer that those are operational
risks a machine breaking down so begins
producing products which are faulty that
is an operational risk fraud
non-compliance with regulations
probably an operational risk if it's
just a slip it could be a strategic risk
that there was a deliberate policy from
the top to try to deceive government and
regulators loss of key people and the
occasional DEP going bad are kind of
operational risks which we have to
really cope with
then we have reporting risks the
reliability of reporting there is a risk
that our financial statements is wrong
there is a risk that if you have to send
in returns the government may be about
employment something of that sort you
know that's sort of information wrong
and so on
I would say that by and large off the
four kind of risk categories we're going
to be talking about probably reporting
risk is it's going to be embarrassing
but it's probably could it be the
cheapest probably and finally there is
compliance risk compliance is where you
failed to comply with rules and
regulations and this can be very very
expensive there can be fines and
sometimes governments would put on
what's called punitive fines finds it
very very high to punish you and to act
as a deterrent for others there could be
damages so if you don't comply with
health and safety regulations and one of
your workforce gets badly injured then
you're gonna have to pay that person
damages and then sometimes there can be
you can actually lose your license so in
the UK as in most countries our
restaurants are inspected to ensure that
they comply with basically food hygiene
regulations and if an inspector goes in
and finds that the the kitchen is disgusting
disgusting
really then the regulatory authorities
can ban the restaurant from trading and
can either ban it from trading until it
cleans stuff up or if it keeps repeating
it can ban them permanently from trading
and so on so potentially very very
all we have in the next few slides and
indeed in the notes it's just a big list
of potential risk you don't have to
learn what these are it's just showing
you that there are many many different
forms of risks so an environmental risk
could be that you release nasty stuff
into the river and probably then
trigging a kind of a regulatory problem
economic risk that may be the exchange
rate moves against you and you found it
hard to export or you find the imports
are very expensive going further on down
here we have financial risk coming in
currencies changing interest rates
changing and and the like has loads of
IT risks viruses hacking machines simply
breaking down and you're not being able
to trade for several days because a
programmer has made an error in the
updates knowledge management that a some
key personnel leave and when they leave
they take with them knowledge which is
very important to the business and the
businesses left / EFT
property risks obviously the property
could burn down it could be flooded
those are property risks but it can also
be that you have bought property and
been trading with it for some years
maybe a shop and then you find that the
area of the town which the shop is
situated has become unfashionable for
people now feel it's it's a bit
dangerous to go to that area of the town
and you're left with this property which
is kind of in the wrong place and
there's a risk therefore that it's not
going to be really earning its keep
other ones here just a couple of these
health and safety risks I've talked
about already having to pay damages and
so on a trading risk perhaps that a
major customer takes business somewhere
you could also bring in their bad bad
debt risk the categorization doesn't
matter very much resource risks you find
it difficult to find enough raw
materials because the raw materials are
very difficult to find or maybe the
country that produces them is going
through some sort of political turmoil
Ford risks that your staff are stealing
from you basically probity risks that
your staff maybe have embarked on
providing maybe bribes to customers to
get big orders coming in and of course
when the the bribery is discovered again
you're going to be in for huge penalties
potentially now almost getting back to
this core conformance performance
balance of God's here a very important
concept and one you have to understand
really is risk appetite as it says here
risk appetite it's a nature and strength
is at risk that we are willing to bear
some organizations are risk seeking and
some are risk averse and it isn't there
one that's right and one is wrong what's
particularly important is that they
don't tell lies to their shareholders so
if you say to your shareholders we are a
company which which takes risks you know
inevitably our business is going to be
one where we take risk we are developing
pharmaceuticals we pump millions of
dollars into this and then may be fine
it's not going to work
it could be a bit of a bumpy ride and
provided the shareholders are happy with
that that's fine other companies will
say we release a fog via money we will
maybe be in food distribution
supermarket company supermarket
companies tend to give thoroughly stable
earnings with everyone needs to eat and
so on
and they provide a day they stay true to
that they just stay in the supermarket
business they don't start diversifying
into other risky areas that that is fine
as well the two things that make up the
risk appetite how much risk are we
willing to bear basically how do the
second one first it is risk capacity the
nature and strength of the risk that the
organization is able to bear for example
what are its cash resources if you have
lots and lots of money in the bank and
you embark on some sort of speculative
development of a new product and the new
product doesn't work okay you've spent a
lot of money but nevertheless you're not
going to go into liquidation because you
still have lots and lots of money in the
bank you have almost the flexibility to
gamble safely if however you've got for
example relatively little money in the
bank and you embarked on a big project
and the big project fails then that
could be the end of you
because you've kind of bet the company
really on this project working and it
could be exactly this is the same
project in both situations but in the
the well-off company it can stand to
lose that money in the less well-off
company it's going to be really dealt a
fatal blow if it loses had money
so it's risk capacity and secondly you
have the risk attitude the directors
views daily these views here should
the directors views of the amount of
risk that the shareholders and they
think the shoulders are willing to bear
you could have a company with lots of
money in the bank it could kind of
gamble a new project safely but actually
the shareholders that what that the
shareholders more than nice safe home
for the savings alternatively you could
have a company with lots of money in the
bank and the shareholders kind of their
want out they they they say you have to
go out you have to push the boat out you
have to try to develop new products I
want to see growth and I'm willing to
undertake a bit of a loss I know that's
what it takes so the two things are as
how much can we afford to lose and
secondly really what is the risk
attitude author directors but ultimately
that should be reflecting the risk
attitude of the shareholders people who
own a company benefits of risk
management is going to be first of all
more predictable cash flows if you give
your credit limits for example to
customers and one of them goes bust then
you've limited the damage the cash flow
is going to be a bit adverse but it's
not going to be deadly adverse if you
like if instead of maybe opening a
hundred branches in a new country at
once you open ten branches see how they
go they go well then you extend your
operations in that new country again you
are having more predictable cash flows
particularly this downside risk it
applies well run systems because
somebody has sat back and thought about
risk and thought about cash flows
thought about the upside and the
downside that might come through if you
don't have any form of risk management
it's almost other people go into
projects or ventures without probably
really thinking about them and
evaluating them properly limitation of
the impact of disaster
so a risk management it a very simple
obvious one is some smoke detectors a
very simple one is if you're reliant on
your computer a standard risk management
technique apart from keeping that
computer secure is if another computer
probably in a different town mirroring
the records on your main computer so one
goes down gets damaged the other one
just kind of starts off immediately
seamlessly and trading continues greater
confidence amongst almost everyone
involved with the organization investors
Louie's customers suppliers and partners
and so on here and there's greater
confidence here if you believe that the
risk is down then this is going to
should say well my costs are going to be
down I'm not going to lose as much
unexpectedly I'm not going to come in
for fines and damages and so on from
people go it's more more predictable
kind of cash flows and what you should
find here is your cost of capital is then
so when you go to the bank and want to
negotiate an overdraft or a loan one of
the things they will think to themselves
is is this a risky place to lend money
to and if you can show that you are
managing your risks well that your
chances of something big and nasty
happening unexpectedly is low that
you're there for nearly always be able
to pay the interest then the bank will
lend you the money to the lower rate
similarly if you go into people and
asking for share capital you can say
well look you know we're very cautious
we're taking some risks but nothing
really nasty is gonna happen and with
those risks were built in nicely
increase our dividends and so on then
people will be willing to invest in you
more readily and more cheaply than they
will invest in a in a company where the
earnings are very erratic where the
track record is very lumpy and so on
dividends kind of going up and down and
coming in the headlines or doing things
wrong and so on the lower the cost of
capital then the higher the share price
should be the share price will be up
then the present value of any project
should also be increased and finally
better matching of the risk appetite of
the shareholders what the company is
actually doing you need to be fair to
shareholders you need to say look if
your investor narcissus is sort of
company we are these are the sort of
risks we undertake these are the sort of
safeguards maybe we put in to make sure
we don't lose too much money
are you interested investing in a
company with that sort of risk profile
what we don't want to be doing is is
kind of luring shareholders into a
company and then then finding it's
really not the type of risk return
balance that they're going to be happy
with and we have to find this acceptable risk
risk
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