Assessment of Financial Risk in Firm 's Profitability Analysis

Abstract

In the context of globalization, the authors are witnessing an unprecedented diversification of risk situations and uncertainty in the business world, the whole existence of an organization being related to risk. The notion of risk is inextricably linked to the return. Return includes ensuring remuneration of production factors and invested capital but also resources management in terms of efficiency and effectiveness. A full financial and economic diagnosis can not be done without regard to the return-risk ratio. Stock profitability analysis should not be dissociated from risk analysis to which the company is subdued. Risk analysis is useful in decision making concerning the use of economic-financial potential or investment decisions, in developing business plans, and also to inform partners about the enterprise's performance level. Financial risk analysis, realized with the use of specific indicators such as: financial leverage, financial breakeven and leverage ratio accompanying call to debt, presents a major interest to optimize the financial structure and viability of any company operating under a genuine market economy.

Headnote

Abstract: In the context of globalization we are witnessing an unprecedented diversification of risk situations and uncertainty in the business world, the whole existence of an organization being related to risk. The notion of risk is inextricably linked to the return. Return includes ensuring remuneration of production factors and invested capital but also resources management in terms of efficiency and effectiveness. A full financial and economic diagnosis can not be done without regard to the return-risk ratio.

Stock profitability analysis should not be dissociated from risk analysis to which the company is subdued. Risk analysis is useful in decision making concerning the use of economic-financial potential or investment decisions, in developing business plans, and also to inform partners about the enterprise's performance level.

Risk takes many form:, operational risk, financial risk and total risk, risk of bankruptcy (other risk categories) each influencing the business activity on a greater or lesser extent. Financial risk analysis, realized with the use of specific indicators such as: financial leverage, financial breakeven and leverage ratio (CLF) accompanying call to debt, presents a major interest to optimize the financial structure and viability of any company operating under a genuine market economy.

Keywords: risk analysis financial risk, financial leverage, breakeven point.

(ProQuest: ... denotes formulae omitted.)

Introduction

Risk and return are two interdependent aspects in the activity of a company, so the question is assuming a certain level of risk to achieve the profitability that it allows. Return can only be assessed but on the basis of supported risk. This risk affects economic asset returns first, and secondly of capital invested. Therefore it can be addressed both in terms of business, as the organizer of the production process driven by intention to increase property owners and adequate remuneration of production factors and the position of outside financial investors, interested in carrying the best investment, in financial market conditions with several areas of return and different risk levels.

Risk assessment should consider managing change: people change, methods change, the risks change [1, 36]. Consequently, profitability is subject to the general condition of risk where the organization operates. Risk takes many forms, each affecting the agents' economic activity on a lesser or greater extent. For economic and financial analysis at the micro level presents a particular interest those forms of risk that can be influenced, in the sense of reduction, through the actions and measures the economic agents can undergo.

1. Financial Risk in Economic Theory and Practice

Financial activity, in its many segments is influenced by unexpectedly restrictive elements as evolution, often unexpected, not depending directly on economic agents. Impact of various factors (market, competition, time factor, inflation, exchange rates, interest, commissions, human factors and not least the company culture) often makes financial decision become a decision under risk.

Financial risk characterizes variability in net profit, under the company's financial structure. There are no financial template features, each business activity prints its own significant variations from case to case. In the case of retailers, "intangible assets are less important, but stocks are significant, and the appeal to credit provider is frequently used, being very useful for treasury business" [2, 40].

An optimal capital structure will maximize enterprise value by balancing the degree of risk and expected return rate.

Management of financial risk is an integral part of planning and financial control, submitted to strategic and tactical decisions for a continuous adaptation to inside and outside company conditions, constantly changing and it requires:

- identification of areas that are prone to risk;

- likelihood estimation of financial risk production;

- determining the independence relations between financial risk and other significant risks (operational risk, market risk - interest rate fluctuations);

- delimitation of risk and keeping it under observation to stop or diminish (minimize) the effect;

- identify causal factors for financial risk, in order to define potential adverse effects induced on the overall activity of the company;

- determining the risk as quantifiable size, as well as the effects associated to risk occurrence;

- determining the routes to follow and strategies to fit the company's financial activity in an area of financial certainty.

Financial risk issues can be found at the heart of Romanian accountant's normalizors. According to the OMPF 3055/2009, the Board must prepare for each financial year a report, called a Managers ' report, which must include, besides an accurate presentation of development and performance of the entity's activity and its financial position, also a description of main risks and uncertainties that it faces.

Thus, Managers report must provide information on: the objectives and policies of the entity concerning financial risk management, including its policy for risk covering for each major type of forecasted transaction for which risk coverage accounting is used, and entity's exposure to market risk, credit risk, liquidity risk and cash flow.

Required disclosures provide information to help users of financial statements in evaluating the risk financial instruments, recognized or not in balance sheet.

The main categories of financial risks affecting the company's performance are [3]:

1. Market risk that comprises three types of risk:

0 currency risk - the risk that the value of a financial instrument {Financial instrument is defined according OMFP 3055/2009, Art. 126, as: ''...any contract that simultaneously generates a financial active for an entity and a financial debt or equity instrument for another entity") will fluctuate because of changes in currency exchange rates; the lowering of exchange rate can lead to a loss of value of assets denominated in foreign currency thus influencing business performance;

0 fair value interest rate risk - the risk that the value of a financial instrument will fluctuate due to changes in market interest rates;

0 price risk - the risk that the value of a financial instrument will fluctuate as a result of changing market prices, even if these changes are caused by factors specific to individual instruments or their issuer, or factors affecting all instruments traded in the market. The term "market risk" incorporates not only the potential loss but as well the gain.

2. Credit risk - the risk that a party of financial instrument will not to comply with the undertaking, causing the other party a financial loss.

3. Liquidity risk - (also called funding risk) is risk that an entity meets in difficulties in procuring the necessary funds to meet commitments related to financial instruments. Liquidity risk may result from the inability to quickly sell a financial asset at a value close to its fair value.

4. Interest rate risk from cash flow - is the risk that future cash flows will fluctuate because of changes in market interest rates. For example, if a variable rate debt instruments, such fluctuations are to change the effective interest rate financial instrument, without a corresponding change in its fair value.

Financial environment is characterized by a high interest rate volatility, which translates in terms of risk and indiscriminate harms the value and profitability of any enterprise [4, 89]. Interest rate risk on the balance sheet is reflected by changes in market value of an asset, as the present value of an asset is determined by discounting cash flows using interest rate or weighted average cost of capital [5, 89].

2. Financial Risk Assessment

Financial risk assessment is performed by using specific indicators such as: financial leverage, financial breakeven and leverage factor (CLF) whose values express fluctuations in net profit, under the company's financial structure change.

Financial leverage effect

Financial risk or capital concerns the company's financial structure and depends on the manner of funding the activity: if it is wholly financed by equity, it will not involve financial risk. This risk appears only if loan financing sources involving charge to pay interest and shows a direct influence on financial profitability (of equity) [6, 170].

Debt, the size and cost drives the variability of results and automatically changes the financial risk. The size of influence of financial structure on firm performance has produced financial leverage effect, which can be defined as the mechanism through which debt affects return on equity, return on the ratio of benefits (net income) and equity.

Between economic profitability and financial return there is a tight correlation. Financial return is rooted in economic returns. The difference between the two rates is generated by company policy options for funding. Usually, on equal economic rate return, financial profitability rates vary depending on finance source - from own equity or borrowed capital.

In economic theory the link between financial profitability rate (Rf) and economic rate of return (Re) is highlighted by the following equation:

...

where: d = average interest rate; D= total debts; Cpr = own equity;

...

If for calculation of return rates profit tax is taken into account, the relationship becomes [6, 170]:

where: i=the tax rate....

We can see the influence that financial structure, respective "all financial resources or capital composition that financial manager use to increase the needed funding" [7, 36], has on the overall profitability of the company. By reporting total debt (D) to own equity (CPR) is determined financial leverage (LF) (or leverage ratio) reflecting the proportion of grants to loans and grants to its own resources. The report should not exceed the value 2, otherwise the debt capacity of the enterprise is considered saturated, and borrowing above this limit lead to the risk of insolvency, both to the borrower and the lender.

The financial leverage effect (ELF) results from the difference between financial and economic return and "expresses the impact of debt on the entity's equity, the ratio between external and domestic financing (domestic resources) " [2, 40] thus reflecting the influence offinancial structure on the performance of an entity:

...

Depending or not on the consideration of income tax, net or gross rates of return can be measured, i.e. net or raw financial leverage effect, as follows:

Debt is favorable while the interest rate is inferior to the rate of economic profitability, which has a positive influence on financial rate of the company.

Financial leverage is even greater as the difference between economic profitability and interest rate is higher, in this respect can be seen several cases presented in Table 1.

Leverage effect allows evolution stimulation for financial profitability according to the change in funding policy of the enterprise being an important parameter for strategic business decisions [8, 164-165].

Based on the balance sheet and profit and loss account of two studied companies' rates of return and financial leverage are determined, as presented in table no. 2.

From the analysis of the data presented in Table 2 we may see the following conclusions:

1. Economic and financial rates of return, in the case of S.C. ALFA S.A. follows an upward trend recently analyzed aspect reflecting the increased efficiency in the use of equity capital invested, while for S.C. BETA S.A. evolution is a descendant one.

2. Return on equity (equity efficiency) was higher than the rate of economic profitability (economic efficiency of assets, invested capital respectively) throughout the period under review following a positive financial leverage (ELF> 0) and higher economic efficiency cost of borrowing (Re> d).

3. Reducing financial leverage for S.C. ALFA S.A. reduced the favorable effect of the debt presence on financial efficiency rate, which was due to lower weight ratio of total debt and equity growth.

4. Total debt increased during N-l and N years for S.C. BETA S.A. resulted in increased financial leverage that potentiates financial return ahead as the economic rate of return.

The evolution of the relationship between gross economic return (Rebr) and gross financial profitability (Rfbr) for S.C. ALFA S.A. is graphically presented in Figure 1, and for S.C. BETA S.A. in Figure 2.

Analyzing the evolution offinancial leverage (Figure 3) one can see that risk capital is not placed at a level too high, which might jeopardize the financial autonomy of enterprises.

Some financiers, as Modigliani and Fisher argue that it is more advantageous for the company to finance from loans than from equity [6, 170] as the cost of borrowed capital (debt interest) is always deductible company's tax, while the cost of equity (preserved benefits and dividends) is not tax deductible for the company. Shareholders tend to fall into debt to get more tax saving, in this way, "indebted enterprise value appears to be higher than the company that is not under debt"[7, 36].

Financial breakeven return

Establishing the company's position in relation to financial return breakeven for financial risk analysis is determined taking into account fixed costs and fixed financial costs, meaning interest expenses. In this situation turnover is calculated corresponding to a financial breakeven return or "financial standstill".

Breakeven thus determined depends on four fundamental variables [10]:

- three parameters that influence the stability results of operations:

* stability of turnover;

* costs structure;

* firm position in relation to its dead point;

- financial expenses level, respective the debt policy practiced by the company.

Based on these values safety indicators or position indicators are estimated, presented in Table 3.

where: CA^tic= financial breakeven;

Cf = fixed expenses;

Chfin = financial expenses

CV= variable expenses;

CA = turnover;

Rmcv = variable expenses rate margin.

Financial risk deepens economic risk (in addition to repayment of loans, interest costs need to be paid), and finally generates a payment default of the company that can lead to bankruptcy risk [11, 36].

Financial leverage ratio (CLF)

Financial risk assessment and evaluation can be made based on financial leverage factor (CLF). It expresses the sensitivity of net income (Rnet) to operating results variations (Rexp) and measures the percentage increase of net income in response to increase with one percentage of results from operations. Calculation relationship is as follows:

...

respective: ...

The CLF calculation takes into account only the current result and financial expenses, only that correlate with the operation, which reduces net income relationship: Rnet = (Rexp - Chfin) *(! - /)

In these circumstances, financial leverage coefficient gains expression: d c. \ /. .vi Rexp

...CLF= RqxP

It notes that the financial leverage ratio is directly proportional to financial expenses which increase higher the value of CLF and therefore increase in financial risk.

Financial risk as measured by financial leverage ratio meets varying degrees depending on knowing the coefficient values from zero to infinity [6, 170]:

Based on profit and loss account of the two studied companies we determine financial risk indicators presented in Table no. 4.

It can be noticed that, based on the data in Table 4, the companies have a comfortable situation in terms of financial risk, because financial expenses have insignificant values, and in N-2 year their absence allowed to obtain a financial leverage ratio equal to 1, companies' exposure to financial risk being minor.

Actual turnover for the two companies were above breakeven financial (over critical turnover) in the analyzed period, aspect which allowed the recording of safety margins, safety spaces and positive efficiency gains.

Graphical representation of comparative evolution of financial leverage ratio is suggestively shown in Figure no. 4.

In the case of S. C. ALFA S.A. the entire period financial risk is minor due to low level of financial costs, the company preferring to use only its own resources to finance the activity. Poor values of financial leverage ratio (very close to 1) support the previous statements.

Greatest financial risk to which S.C. BETA S.A. is exposed to is manifested in financial year N, when the value of coefficient CLF is maximum, respectively 1,11047 which shows increasing dependence of net result on the operating result, and consequently, increased financial risk due to the gap between the index and results of operations index of financial expenses (lRexp < Ichfin)- However, financial risk is minor, the society proves superior financial performance as turnover is well above the critical turnover (financial breakeven), range safety hovering well above the 20% in the analyzed period.

Conclusions

Debt had a positive effect on financial profitability manifested as a "financial leverage" (positive leverage effect). Extremely low level of debt and lower value of financial liabilities inferior to own equity makes companies not risky in terms of financial solvency. In this situation, for both companies, is more advantageous to use the medium and long term loans to finance business, thus ensuring them an additional profit. Using debt should be made with caution in order not to limit the financial independence of firms and reduce additional debt opportunities in times of crisis.

Analysis of financial risk and leverage effect that accompany the call to debt, presents a major interest to optimize the financial structure and viability of any company operating under a real market economy.

The use of loans can be risky for the entity and its shareholders, but this method of financing becomes advantageous for entity shareholders simply because they are able to hold an asset more important than equity value, increasing their economic power. The financing of company expansion activity can be achieved by a significant increase in borrowed capital provided economic returns exceed the average interest rate.

Company's risk assessment on the basis of leverage coefficients is required for the predicted behavior analysis for estimating future results, which must be taken into account in decision making process.

References

References

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[3] OMFP, 3055/2009, Art. 306, al. (3).

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