What factors affect the risk of business firms?

Answer 1

ANALYSIS OF RISK

Analysts deciding between investments must consider the comparative risks. Various factors affect the risk of business firms:

1 . Economy-wide factors, such as increased inflation or interest rates, unemployment, and recessions.

2 . Industry-wide factors, such as increased competition, lack of availability of raw materials, changes in technology, and increased government regulatory actions, such as anti-trust or clean environment policies.

3 . Firm-specific factors, such as labor strikes, loss of facilities due to fire or other casualty, and poor health of key managerial personnel.

Analysts assessing risk generally focus on the relative liquidity of a firm. Cash and near-cash assets provide a firm with the resources needed to adapt to the various types of risk; that is, liquid resources provide a firm with financial flexibility. Cash links the operating, investing, and financing activities of a firm, permitting it to run smoothly and effectively.

Assessing liquidity requires a time horizon. Consider the three questions that follow:

1 . Does a firm have sufficient cash to repay a loan due tomorrow?

2 . Will the firm have sufficient cash to repay the same loan due in six months?

3 . Will the firm have sufficient cash to repay the same loan due in five years?

In answering the first question, the analyst probably focuses on the amount of cash on hand and in the bank relative to the obligation coming due tomorrow. In answering the second question, the analyst compares the amount of cash expected from operations during the next six months, as well as from any new borrowings, with the obligations maturing during that period. In answering the third question, the analyst shifts the focus to the longer-run cash-generating ability of a firm relative to the amount of long-term debt that will mature. Ultimately, analysts assess whether a firm will likely become bankrupt; creditors and investors may lose the funds they provided to a bankrupt firm.