ESSENTIALS

of Financial Risk
Management

Parvesh Aghi
Identifying Major Financial Risk

Operational risk refers to the chance of loss stemming from an issue

with people, systems, procedures, and external events .
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Debt usage & leverage risk

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Meaning of leverage

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TYPES OF LEVERAGE

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Financial leverage

Companies with high FL have

underperformed during lockdown 6
Financial Leverage

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Risk of bankruptcy

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Operating leverage

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Operating leverage

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Operating Leverage

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Low operating leverage industries

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High operating leverage companies

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High financial leverage industries

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Optimum Financial leverage

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Optimum Financial leverage

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Factors Considered in the Capital Structure Decision-
Making Process

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Optimal operating leverage

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How does financial risk arise?

» There are three main sources of financial risk:

1. From changes in market price, such as interest
rates, exchange rates, and commodity prices

2. From the actions of, and transactions with, other

organizations such as vendors and customers
3. From internal actions or failures such as people,
processes and systems

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What is financial risk management
» Financial risk management is a process to deal with
the uncertainties resulting from financial markets
» It involves:
» Assessing the financial risk facing an organization
» Determining level of risk tolerance
» Develop and implement strategy for managing risk
» Measure, report, monitor, and refine

» Remember the strategy of taking no action is the

acceptance of all risk

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» There are three main sources of financial risk:
» Financial risks arising from an organization’s exposure to
changes in market prices, such as interest rates,
exchange rates, and com- modity prices
» Financial risks arising from the actions of, and
transactions with, other organizations such as vendors,
customers, and counterparties in derivatives transactions
» Financial risks resulting from internal actions or failures of
the organ- ization, particularly people, processes, and
systems

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Diversification

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Diversification

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Diversification

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Diversification

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1

» Operating leverage is the relationship

between company’s…………….
A.Variable & other costs
B.Fixed & variable costs.
C.Fixed & other cost
D.Operating cost & other costs

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2

» Retailers and labour-intensive industries such as

restaurants and accounting companies
have…………….
A.low operating leverage
B.high operating leverage
C.High financial leverage
D.Low financial leverage

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3

» Financial leverage is the use of ………..to

finance the purchase of assets
A.Equity
B.Debt
C.Preference share capital
D.All of of above

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4

» Leverage is the strategy of using borrowed

money to increase ……… on an investment
» Return

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5

» Higher operating leverage is related to the use

of additional __________.
A.Fixed cost
B.Variable cost
C.Debt financing
D.Common equity financing

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6

» Lower financial leverage is related to the use

of additional __________.
A.Fixed cost
B.Variable cost
C.Debt financing
D.Common equity financing

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7

» Which of the following costs would be

considered a fixed cost?
A.Raw material
B.Deprecation
C.Production labour
D.fuel

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8

» The measure of business risk is……

A.Operating leverage
B.Financial leverage
C.Total leverage
D.Working capital leverage

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9

» Degree of total leverage can be applied

measuring change in…….
A.EBIT to percentage change in quantity
B.EPS to percentage change in EBIT
C.EPS to percentage change in quantity
D.Quantity to percentage change in EBIT

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10

» Degree of financial leverage is a measure of

relationship between
A.EPS and EBIT
B.EBIT and quantity produced
C.EPS and quantity produced
D.EPS and sales

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» The leverage effect is positive when the
earnings of the firm are higher than the fixed
charges to be paid for the lenders.
The leverage is an important factor which is
having impact on the profitability of the firm and
the wealth of the shareholders can be maximized
when the firm is able to employ more debt

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What Are Operational Risks?
» If you're running a business, you naturally would like to
mitigate risk. You'll have to understand that risk first
though.
» Operational risk refers to the chance of loss stemming
from an issue with people, systems, procedures, and
external events. This is the broad definition, more narrow
definitions limit the risk solely to events arising from
within an organization, or even more specifically, to
those caused solely by human error.
» In this lesson, we go over the subcategories of
operational risk from a broader perspective and provide
examples of each.

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People
» Operational risk can result in significant loss for a company due to accidental
or purposeful human error. There are numerous potential scenarios where
this might be the case.
» For instance, a company might hire poorly trained or inexperienced personnel
in lieu of more appropriate individuals as a cost-saving measure. These
inexperienced employees may make innocent mistakes that result in loss.
Say a manufacturing plant hires inexperienced contractors who end up
fumbling their duties, leading to mechanical breakdowns and production
delays.
» In other cases, the operational risk and loss stems from pre-planned
detrimental activity. Generally, this refers to examples where people commit
criminal offenses that harm the company and, potentially, those involved with
the company. Think of Bernie Madoff, who went unchecked in creating a
Ponzi scheme that not only doomed his own organization and its staff but
also the finances of countless others around the world.

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1

» Given Sales Rs.100

million, Variable cost
Rs.40 Million and
Fixed Cost Rs.40
Million.
» Find out the Degree of
Operating Leverage.

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1
» Given Sales Rs.100 million,
Variable cost Rs.40 Million
and Fixed Cost Rs.40 Million.
Find out the Degree of
Operating Leverage.

» Contribution =100-40 =60

» EBIT = 100-40-40 = 20

» OL = 60/20 = 3

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2

» Given Sales Rs.100 million,

Variable cost Rs.48 Million and
Fixed Cost Rs.30 Million. Find out
the Degree of Operating
Leverage?

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2

» Given Sales Rs.100 million, Variable cost Rs.48

Million and Fixed Cost Rs.30 Million. Find out the
Degree of Operating Leverage?

» High operating leverage produces a situation where a small change

in sales can result in a large change in operating income [Sales –
Variable cost – Fixed cost]

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3

» Situation A: Given Sales Rs.100 million, Variable

cost Rs. 40 Million and Fixed Cost Rs. 40 Million.
» Situation B: Sales Rs.80 million, Variable cost
Rs.32 Million and Fixed Cost Rs.40 Million.
» Required :
» Compare operating income.
» Degree of Operating Leverage
» Which business is more risky ?

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3
» Situation A: Given Sales Rs.100 million, Variable cost Rs. 40 Million and Fixed Cost
Rs. 40 Million.
» Situation B: Sales Rs.80 million, Variable cost Rs.32 Million and Fixed Cost Rs.40
Million.

» Situation A
» Operating income = 100-40-40 = 20
» Degree of Operating Leverage = contribution / operating income
» 100-40 / 100-40-40 = 60/20 =3
» Situation B
» Operating income = 80-32-40= 8
» DOL = 80 -32 /80-32-40 = 48 / 8= 6
» Business B is more risky

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4

» Situation 1: Given Sales Rs.100 million, Variable

cost Rs.60 Million and Fixed Cost Rs.20 Million.
» Situation 2: Sales Rs.80 million, Variable cost
Rs.48 Million and Fixed Cost Rs.20 Million.
» Compare operating income/ operating leverage

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5
» Given Sales Rs.100 million, Variable cost Rs.40 Million
and Fixed Cost Rs.40 Million. Capital employed of the
Company Rs.80 million with debt equity ratio 1:1 Debt
carries 10% interest.
» Required :
1. Find out the Degree of Financial Leverage/ operating
leverage?
2.Now assume that sales change to Rs.80 million. prepare
a statement showing operating profit and PBT in both the
situation and then explain the change in profits using DOL
and DFL.

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Solution:

» Find out the Degree of Financial Leverage?

» Interest cost = Rs.4 million.
» (Figures are in Rs. Million)
» 100-40-40 / 100-40-40-4
» 20 / 16 = 1.25
» Operating leverage = contribution / EBIT
» 60/20 = 3

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EXERCISE
» Given Sales Rs.200 million, Variable cost Rs.70 Million
and Fixed Cost Rs.100 Million. Capital employed of the
Company Rs.70 million with debt equity ratio 5:2 Debt
carries 15% interest.
» Required :
» Find out the Degree of Financial Leverage / operating
leverage ?
» Now assume that sales change to Rs.220 million.
prepare a statement showing operating profit and PBT in
both the situation and then explain the change in profits
using DOL and DFL.

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