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Risk Factors in Financial Planning

August 8th, 2006

One of the most important factors in analyzing assets is determining the degree of risk they involve. Risk is often defined in terms of loss or injury, or the degree of uncertainty of the outcome.
Assets may be associated with different types of risk.

Economic risk

Assets will react to various economic changes. During inflationary periods, costs increase and consequently, purchasing power declines. The opposite occurs during depressions or severe recessions because prices decline. Thus, the value of assets can increase or decline during economic cycles.

For example, with inflation the value of real estate increases. On the other hand, in a depression, real estate prices decline. When the price of a parcel of real estate falls below its outstanding debt, the owner will often walk away from it. This happened many times during the depression.

Interest rate risk

Many interest-producing assets, such as bonds, CDs, and preferred stocks, pay a fixed return over a period of time. As interest rates increase or decrease, the market value of these assets changes. For example, a 10-year, 12 percent government bond is assured of a 12 percent annual return over the life of the bond. But a sharp rise in prevailing interest rates would batter its resale value in the bond market. Of course, the bondholder in this case would suffer no loss of principal if he held the bond; but he would forego the higher interest return.

Business risk

Exposure to competition in the marketplace-or simply an unforeseen event-can dramatically affect a company’s operations or a specific industry as a whole. When this occurs, net cash flows and profits can decrease and the potential for default on the company’s outstanding debt can increase. An example of a very competitive industry is computers. Some investors obtained high profits by investing in new companies in this field, yet others lost money when a major industry shakeout took place in 1984.

Liquidity risk

Liquidity is the ability to quickly sell an asset at its current market price. Marketable securities are an example of a liquid asset because they can easily be traded at the current market price. (This, of course, does not mean that the securities won’t be sold at a loss.) Compare this situation to the sale of a nonliquid asset such as real estate or an art collection. It may take several months or more to find a buyer who will pay the current market price. This type of asset could probably be sold quickly if the current market price were greatly reduced.

Taxation risk

Some assets will generate no tax liability, such as the sale of personal residence by a person age 55 or over. Other assets, such as certain tax shelters, can generate enormous problems at the time of acquisition or sale. Knowing the potential or incurred tax liability is essential in matching assets to objectives and in considering repositioning assets.

Political risk

Government actions can have a negative impact on assets. Through regulations, tax code changes, excise taxes, etc. the government can change the profitability of companies and the market value of assets.

Market risk

The mood of the investing community often fluctuates in dramatic and unpredictable ways. The market values of real assets and marketable securities are subject to these moods. For example, when the economy goes into a recession, investors become pessimistic about the future, and the stock market value of most companies declines-even of companies that are showing record profits.

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Tags: Community, Depression, money, profit, profitability, profits
Posted in Economy, Finance, Investment, Management | Comments (2)

2 Responses to “Risk Factors in Financial Planning”

1. Business Valuations Appraisal » Blog Archive » Business Valuation Risk Factors Says:
   March 5th, 2008 at 10:57 am

   [...] Business Valuation Risk Factors Defined: In addition to the appraisal approaches, risks must also be taken into account when performing a business valuation. Risk factors will vary between companies, industries, and are likely to change over time. Generally, risks are categorized into three groups: business risk, financial risk and liquidity risk. Business risk: This is applied to all factors that may affect forecasted earnings. This includes any issue that may impact upon administrative and operating expenses, cost of sales and sales. Business risk is normally determined on a company specific basis, and requires the appraiser to understand the competition, industry, management focus and working capital of the company. Financial risk: This is applied to interest expense, which has the capability of affecting forecasted pre-income tax earnings. Financial risk is nearly always developed to be company specific and is assessed on a businesses asset base. Financial risk is considered to be minimal if the business if financed mainly by equity. Financial risk will likely be considered to be medium to high if the business is financed mainly with debt. Liquidity risk: This is applied to the process of disposing of a business at fair market value. Liquidity risk is not company specific, and is based upon the current industry. [...]

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