Question

1. How the financial risk is measured?
2. Describe three methods of how a person might reduce the risk she / he faces and give examples

Answer 1

a. Financial Risk is caused by inability to finance the Business including short term (liquidity) and long term (solvency).

Financial Risk can be measured by computing various ratios.Some of the ratios that are commonly used to assess financial risk are as follows

1. Interest Coverage Ratio - This ratio indicates company's ability to meet its short term financing costs. It indicated number of times a company is able to pay annual interest on its outstanding debt from its net earnings for the year. Lower of Interest Coverage ratio implies that company has a huge debt burden

2.Financial Leverage ratio(FLR) - This ratio is computed to analyse the ratio of company's assets that is financed by debt.Higher FLR , Higher chances of default or financial insolvency

3. Debt ratio - This is similar to FLR. Higher of this ratio indicates higher financial risk

4. Debt to equity ratio - Debt equity ratio is a comparison between debt financing and equity financing. Higher debt Equity ratio increases the cost of raising additional finanacing as the company is portrayed to be financially riskier.

Financial Risk can be lessened by adjusting the cost structure of the company. Proper mix will reduce the bankruptcy risk and agency cost at an acceptable level

-----------

b.Risk Response involves reducing risks to an acceptable level by employing certain tactics

Three methods a person would do to reduce any type of risk are as follows

1.Avoidance

This response involves exiting the activity that give rise to the risk

For example : If a risk averse company is planning to invest in another company which has high financial obligations , the probable solution would be to avoid investing in it.

2. Risk Reduction -

This involves Taking actions to reduce the likelihood or imapct or both .

For Example : This might involve managing the risk or adding additional controls to process .

For instance , to reduce the risk of theft of goods , company can make use of digital security devices like cctv survellience, alarms, etc

3.Transfer

This response involves transfering the risk using techniques like insurance, hedging,outsourcing etc.

For example : A company can reduce the risk of loss from fire by insuring the goods through fire insurance.