Business 2K Blog Place

• Home
• About Business 2k Blog Place
• Building Your Own Prospect Database
• Mortgage Advice. The Complete Guide

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.

Related posts:

1. Analyzing Assets If a client’s aims remain ambiguous and vague, a financial planner must help clarify them. Clarification is the predecessor to qualification of these objectives. To avoid any resemblance to an inquisition, the purpose of the assets and their relationship to the various types of high risks and rewards must be reviewed. Risk factors. One of the [...]...
2. Marketable Securities Investing in marketable securities has become increasingly popular because many see it as a means to achieve their financial goals. Some invest in these vehicles for long-term growth or to preserve purchasing power. Others require income, while some desire speculative short-term profit. Although investors’ expectations differ, financial planners will seek to match specific objectives with the [...]...
3. Long Term Debts In addition to the U.S. government, the major issuers of debt in ; this country are corporations. There are many classifications of corporate debt, commonly referred to as bonds. They all involve some variation of the following contractual promises: (1) interest will be paid periodically, and (2) the principal will be paid at a predesignated time. Usually [...]...
4. Intestacy in Financial Planning Titling assets is an important aspect in coordinated estate planning, but it is only the first step. The real key is to determine the clients’ objectives. Do they have goals for passing assets to the next generation, or is a charitable beneficiary of primary importance? Because defining these goals is not easy, many clients fail [...]...
5. Risk versus Return With all types of investments, there is a direct relationship between risk and return. That is, the higher the expected return, the riskier the investment is likely to be. Unscrupulous investment dealers’ claims that tout “high returns with no risk” are misstating the investment’s relative risk, return, or both. Why? Because if there were such [...]...
6. Default Risk in Lender Borrower Relation In any financing decision there exists the possibility that the lender (investor) will not be able to obtain repayment of the loan. This possibility is referred to as default risk the borrower simply is unable (or refuses) to repay the debt. If the borrower has pledged real estate as security, the lender then has the [...]...
7. Investment Securities A common concern for small investors is the difficulty of purchasing a diversified group of assets in order to minimize risk. However, for small investors, the cost of diversification may be prohibitive. For example, most bonds have face values of $1,000 and are sold in blocks of five units. The typical trading unit of stock [...]...
8. Real Estate Limited Partnerships Real estate has long been the backbone of many investment portfolios. In point of fact, statistics show that more money has been placed in real estate partnership than in other types of investment partnerships. Motion pictures and television programs have dramatized the fear, excitement, greed, riches, and scarcity factors which this vehicle can produce. This [...]...
9. How Much Debt? The difficult questions facing the borrower is the optimal amount of debt to use in financing the investment. In our previous example, we saw that the use of debt increased the return on equity from 8.78 to 9.20 percent. And we noted that the equity position is also subject to more risk with the use [...]...
10. Estate Planning Estate planning is often synonymous with a depressing subject-death. Because of that, clients will often procrastinate rather than address the critical issues involved with this type of planning. Overcoming this psychological barrier requires a great deal of skill on the part of a financial planner. However, motivation may increase as clients become aware of the [...]...

Tags: cash flow, Community, Depression, Market, money, Price, profit, profitability, profits, risk
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. [...]

2. Instant Cash Secrets Says:
   December 14th, 2008 at 12:41 pm

   make money…

   online, money, cash, income, make money, surveys, affiliate…

Leave a Reply

You must be logged in to post a comment.