Any meaningful valuation of a company requires an analyst to estimate its future cash flows in tandem with estimating potential risks associated with these cash flows. What impacts a company’s overall risk level? That would be the company’s cost structure, which consists of fixed and variable costs, as well as its capital structure, which consists of debt and equity.
Business risk stems from the risks associated with both a company’s sales and its operations. Income from operations is volatile because revenues and operating costs are inherently uncertain, as they can be impacted by a multitude of factors, such as, for example, overall economic conditions, the level of competitiveness in a market, government-imposed regulation, changing demographics, etc. These risks factors are also referred to as sales risks.
In addition to sales risks, any thorough evaluation of a company must also address its operating risks, which are associated with the company’s operating cost structure, or more specifically, with the company’s fixed operating costs. Understanding the concepts of operating risks is simple—the greater the fixed operating costs compared to variable operating costs, the greater the risks from operations.
Both sales and operating risks constitute a company’s overall business risk, and both are primarily determined by the type of business and markets the company is in. Note that in the grand scheme of things, the company’s management can exercise more control over operating (internal) risks than on sales (external) risks.
For example, let us assume that a company has decided to buy equipment that will produce a new line of products. The sales risks will remain the same regardless what piece of equipment is bought. However, the operating risks will be significantly impacted by the purchased equipment, and dependent on the new ratio between the company’s fixed and variable costs of manufacturing the new product.
Companies that are exposed to the higher level of operating risks are those that are extremely capital intensive during the process of manufacturing their products, but which spend, in comparison, significantly less on marketing finished products. Fitting the description are, for instance, the companies operating in the software and pharmaceutical industries. In contrast, companies with low operating and high sales risks are retail companies, since a great deal of their costs of goods sold are variable, rather than fixed. So, companies that have more fixed costs as opposed to variable costs in their operating structures are also likely to experience more volatility in their net earnings as revenues fluctuate.
Note, however, that the problem with analyzing a company’s business risk is that most companies produce a plethora of products, so estimating the ratio between fixed and variable costs is often difficult. One way to get at least an idea of this ratio is to compare and weigh sensitivity of changes in a company’s operating income to changes in its net sales.
Financing risk stems from how a company’s operations are financed. If a company finances its operations by issuing debt, it is bound by its legal covenants to pay regular interest payments and principal upon maturity. Since these obligations cannot be avoided, the more debt there is in the company’s capital structure, its financial risk increases exponentially.
If, on the other hand, a company finances its operations with equity, either generated from retained earnings, or from issuing new equity, at least there are no fixed, legal obligations to pay off fixed costs.
Benefits of Business and Financial Risk Analysis
When evaluating a company, an analyst is concerned with the combined effects of business and financial risks because both types of risks have significant impact on the company’s future cash flows. By the same token, when the company’s management is making investment decisions, they must consider how their decisions will impact the company’s operating cost and capital structures, which, again, ultimately leads to their ability to generate consistent and increasing future cash flows.