Assessing a Company's Future Financial Health
Overview
People should understand the impact of different types of risk on financial health, whether they’re dealing with personal or corporate finances. The risks involved with personal finance often only impact individuals and families—for example, when determining if you can afford to buy a house or deciding whether to invest in stocks. Financial risks for businesses often affect multiple people throughout the entire company, including individuals who do not work in the finance department. When businesses make finance-related decisions, it is essential that they know how their decisions will impact different aspects of their company.
Prompt
Read the Assessing a Company’s Future Financial Health case study, then write a response.
Specifically, you must address the following rubric criteria:
Systematic and Unsystematic Risk: Explain the differences between systematic and unsystematic risk.
Financial Risks: Describe the potential impacts of the following types of financial risk on the company featured in the case study:
Interest rate risk
Economic risk
Credit risk
Operational risk
Lower Growth Impact: Explain the impact a lower growth in sales could have on the dividend policy and retained earnings for the company featured in the case study.
Higher Growth Impact: Explain the impact a higher growth in sales could have on the dividend policy and retained earnings for the company featured in the case study.
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Assessing a Company’s Future Financial Health
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Systematic and Unsystematic Risk
Systematic (non-diversifiable) risk is the market risk that depends on the market. Systematic risk is measured through beta and can only be reduced if there are no financial securities or assets in a specific market. Systematic risk is equal to the security’s beta where betas less than 1 will reduce the market risk, betas greater than 1 will increase the market risk. Since diversification does not reduce the systematic risk, hedging and asset allocation strategy are the alternatives to reduce the total risk (Ehrhardt & Brigham, 2016). Portfolio managers try to minimize exposure to systematic risk. Some portfolio managers tend to select securities with the lower beta, but this may be inconsistent with the financial objective since the risk affects the market as a whole systematic risk is an unpredictable risk that is avoidable.
Unsystematic (diversifiable) risk is the intrinsic risk in a company or industry that affects profitability, and diversification of financial securities helps reduce unsystematic risk. Since unsystematic risk arises from the uncertainty surrounding a company’s business operations identifying the specific factors associated with risk is necessary to determine how to diversify and reduce unsystematic risk. The systematic risk and unsystematic risk are part of the total risk of a financial asset or security.
Financial Risks
Interest rate risk
The interest rate risk reflects the risks associated with interest rate volatility, which affects the capital. Interest rate exposures affect the assets and liabilities where interest rate changes and volatilities can positively or negatively affect the interest rates of assets and liabilities. The company has interest-bearing debt, and debt payment obligations are likely to increase in the future (Piper, 2012). There is exposure to interest rate risk, affecting the company’s operations and cash flow negatively. A fixed interest rate contract helps to counteract the interest rate risk where the fixed interest rate is higher than the variable interest rate at the time of contracting. It also provides more security in terms of changes. Other strategies are counteracting the effects of possible rate hikes and hedging fixed-income investments.
Economic risk
Economic risk is the likelihood that macroeconomic conditions of the whole economy affect growth prospects and investment. These conditions affect all industries and sectors of the economy, but it is challenging to foresee the economic risks. The macro...