Academic journal article IUP Journal of Applied Finance

Business and Financial Risks in Indian Corporate Sector: An Empirical Analysis in the Post-Liberalization Era

Academic journal article IUP Journal of Applied Finance

Business and Financial Risks in Indian Corporate Sector: An Empirical Analysis in the Post-Liberalization Era

Article excerpt

Introduction

Risk management is essential for a firm to stabilize its earnings and to add value to its owners' wealth. So, in today's challenging and competitive environment, the task of designing appropriate strategies for managing risks in accomplishing the wealth maximization objective of corporates is of utmost importance. All organizations have to face risk of some form or the other. Nothing wrong with that; for, risk-taking is intrinsic to growth (Vedpuriswar, 2005). Since risks and returns go hand in hand, corporates cannot avoid the associated risks completely. Taking no risk may mean forgoing rewards. Managing risk aims at ensuring that risk remains at an acceptable level or within an acceptable range. Therefore, for the achievement of entity objectives, corporates should manage risk to be within their risk appetites.

The total risk which a company is exposed to can be broadly divided into two components-business risk and financial risk. Business risk is inherent in the business operations of the company. It is reflected in the volatility of the expected operating profitability of the company. Business risk is caused by several factors which can be categorized into three groups: (i) economy-specific factors, (ii) industry-specific factors, and (iii) company-specific factors. Economy-specific factors are those which affect all the sectors of the economy, such as fluctuations in foreign exchanges, competition, concentration of revenues, inflation, imports, and restrictive regulations. Industry-specific factors relate to the industry to which the company belongs. Special status enjoyed by the industry, growth prospects in the market for the products of the industry and so on are included in this category. Company-specific factors are identified as human resource management, liquidity, quality and project management, intellectual property management, cost structure, culture, values and so on. Business risks arising out of economy-specific, industry-specific and company-specific factors are regarded as economy risk, industry risk and company risk respectively. The genesis of company risk, in fact, lies in the instability on the company's one or more fronts, important of which are instability in cost behavior pattern, instability in generating sales revenue using capital base, and instability in short-term debt paying capability (Ghosh, 1997). These inherent weaknesses lead to cost structure risk, capital productivity risk and liquidity risk. Financial risk emanates from the financing decisions of the company. It arises out of the possibility of failing to meet contractual obligations and the possibility of fluctuation in income available to owners' equity. So, the financial risk of a company stems from its capital structure. If the company continues to lever itself, all other things being the same, the probability that the company will be unable to meet its contractual obligation goes up, which results in increase in the degree of financial risk associated with the company.

It is well accepted that business risk of a company remains largely uncontrollable, while financial risk is well within its control (Chakraborty, 1981). As there is less scope to exercise greater control in respect of business risk, attempt should be made to control the degree of financial risk. So, it is expected that a company having high business risk should maintain low financial risk by maintaining low fixed charge bearing capital to owners' equity ratio in order to keep its total risk within a reasonable limit. Therefore, theoretically, there is expected to be a high degree of negative association between business risk and financial risk. However, several studies reflect an absolute reverse situation which fails to conform to the theoretical argument (Sur, 2007). It is expected that high risk can be compensated by high risk premium, i.e., high return. No company can carry high risk-low return profile in the long run (Ghosh, 1997). …

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