Every individual, organisation or nation is exposed to risk in one form or the other. Several definitions have been advanced by authors of various disciplines to aptly describe the concepts of risk and risk management. The foregoing possibilities notwithstanding, the writer places emphasis on risk inherent in organisations and how corporate leaders could effectively manage those risks. The emphasis on organisations notwithstanding, the concepts discussed here may be applied to economies and individuals. For the purpose of this write-up, risk is defined as the probability of occurrence of an unfavourable event. Thus, risk exists when the eventual outcome of an activity does not inure to the social, professional and economic benefit of the target.
Risk management can be described as the ability of organisational leaders to identify transactions or activities with negative impacts, and subsequently putting the requisite measures in place to effectively prevent or minimise those undesirable impacts.
Types of Risk
An organisation may be inevitably exposed to diverse forms of risk. Generally, risk can be categorised into two: Internal risks and external risks. Internal risks are those risks that arise within an organisation and which management could device strategic internal mechanisms to effectively avert or minimise their occurrence. Stated differently, internal risks are those risks that emanate from the day-to-day operations of an organisation, and which the organisation’s management could have control over. Examples are risks posed by previous, current and third party’s employees (outsourcing employees).
Summary dismissal of an employee by an employer may result in the former developing bitter feeling and ill-motive about the latter. To this end, the aggrieved (dismissed) employee may seek revenge by clandestinely destroying a valuable property of the employer.
A former employee who gains employment elsewhere may be used by the new employer to obtain key information from the former employer. This situation becomes very feasible when the old and new employers of the implied employee are competitors in the same industry.
Similarly, present employees who lack the requisite skill and training on the job may inadvertently commit functional or occupational blunders, which would be injurious to their employers in diverse ways; the blunder may affect employers, productively and financially, among others.
In some cases, existing employees may possess the needed skill and training, but may not be happy about certain pronouncements by their employers; or their conditions of work. Eventually, the affected employees may resort to actions and behaviours that are inimical to the operational success of their organisations.
In employers’ bid to reduce operating cost, they may outsource some operational functions to third party’s employees. Such a move may grant external (third party) employees access to vital and sensitive information of the outsourcing firm. Here, customers of the outsourcing firm may be exposed to identity theft; valuable information of customers may be transmitted by third party’s employees to cyber “assailants.” The financial accounts of victims (customers) may be drained when this form of risk is recorded in the financial sector of any given economy. A cybercrime expert with an information on the accounts of bank customers may empty the latter’s accounts through the use of automated teller machines (ATMs), electronic transfer systems, and other sophisticated technological devices amenable to financial theft.
External risks are those risks that arise from factors attributed to the environment in which the affected organisation operates. In other words, external risks are risks characterised by conditions beyond the control of the affected institution. Here, conditions and factors prevailing in the macroeconomic environment determine the extent to which an institution is exposed to risk. Some of these risks include input risk, financial risk, property risk, demand risk, and environmental risk. Each of the foregoing examples is briefly explained.
An input risk explains risk associated with the cost of production factors such as labour and materials. As an example, a furniture company may face an input risk when the price of wood increases, and it is unable to pass the increase on to its customers. Similarly, an airline company may face an input risk when the price of fuel increases, and it is unable to review its airfares upwardly. Trade unions may agitate for better conditions of service for labour. If this call is heeded, a firm’s total cost of production would increase; the cost component of labour would increase. The firm would face an input risk if it is not able to increase the unit price of its finished products to offset the increase in labour cost.
Financial experts have advanced a succinct explanation for financial risk. They note fluctuations in foreign exchange rates and interest rates may result in unexpected financial losses to individuals, businesses, and economies in general. For instance, a fall in value of the Ghanaian cedi against major currencies such as the United States dollar means Ghanaian importers would require more cedis to import the same quantity of goods and services into the country.
Property risk relates to the likelihood for an organisation’s operating assets such as equipment and building to be destroyed by fire, flood, or riot. The recent spate of fires recorded in major markets in Accra and Kumasi, pharmaceutical depot in Tema, and domestic homes in some parts of the country; and the recording of floods in major cities across the country had devastating effects on state, corporate, and individual properties. Human lives were even lost in some cases.
A demand risk occurs when customers’ inability to effectively patronise the goods and services of a firm tend to have negative implications for its operations and financial standing. Suppose Company A invests heavily to increase its production capacity from 250,000 units to 470,000 units of finished products in a given year. Each unit is expected to be sold at GHC 5.00. Company A expects customers to purchase all the units in the year. The expected revenue for the year is GHC 2,350,000 (470,000 units x GHC 5.00). If customers’ demand for the entire year is 325,000 units, the company would record an ending inventory or closing stock (unsold units) of 145,000 units; Company A’s expected revenue for the year would reduce by GHC 725,000 (GHC 2,350,000 – GHC 1,625,000), representing about 30.85% reduction in projected revenue. An approximated 31% reduction in consumers’ demand is significant. This would invariably have negative implications for Company A’s finances.
An organisation may be exposed to environmental risk. An organisation’s failure to maintain clean and safe environment may result in legal actions by the Environmental Protection Agency (EPA) against it. Legal judgements by the law courts in favour of the EPA would have negative implications for the affected firms’ finances.
Importance of Risk Management
Effective management of risk by stakeholders would help to achieve the following results.
- Elimination of, or reduction in a firm’s perceived financial distress, including loss of customers, bankruptcy cost, and higher interest payments on debt, etcetera.
- Possession of knowledgeable and skilled personnel to ensure a comparative advantage in hedging.
- Stability in an organisation’s stream of cash flows. A stable firm may not be susceptible to risk.
- Maintenance of an optimal capital structure over a considerable period of time.
- Lower tax payments through stable reported earnings over a long period.
- Determination of adequate compensation packages for managers.
- Reduction in operating costs through the use of derivatives such as interest rate swaps.
Risk is an important factor that militates against the smooth, progressive and successful development of all forms of organisations: small-, medium- and large scale organisations. It is therefore, imperative for managements of institutions, irrespective of the size of the institution, to identify the nagging risks inherent in their day-to-day, medium-term and long-term operations; and take proactive steps to avert their negative impact on the institutions’ operations. Adaption and implementation of these strategic steps would place the institutions on their financial “winning ways,” and give them an edge over their competitors in their respective industries.
Ebenezer M. Ashley (PhD)
The Author is a Senior Consultant at Ghana Investment Services Centre,
Founder of Eben Consultancy,
Fellow and Council Member of the Institute of Certified Economists of Ghana (ICEG)