CHAPTER-5 BUSINESS RISK AND VALUE ADDED: AN IMPACT ASSESSMENT AND ANALYSIS. Business and risk are inseparable. The nature and the magnitude of risks

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1 CHAPTER-5 BUSINESS RISK AND VALUE ADDED: AN IMPACT ASSESSMENT AND ANALYSIS Business and risk are inseparable. The nature and the magnitude of risks that companies have to cope with increased at a mind-blogging rate in the recent times. Each of these, though emanating from unexpected corners has a definite impact on the bottom lines of the companies. a) Loss of the business assets b) Loss of the income due to death, illness, accident of the owner of the business firms. c) Liability towards third parties: Producers, wholesalers, retailers all of them store a possible quantity of stock, and they are bound to suffer the loss till the stock tasts. Therefore, a business should determine and evaluate the risk in the business. Before determining and evaluating the business risk and its variety in select cement companies in India, it would be very much required to understand in brief, the nature of business risk. Hence, nature of business risk is understood by perusing certain points. 1) Risk is unavoidable or essential part of the business. Nobody can escape from the risks in business. Business risks can only be minimized but cannot be eliminated. According to Peter F Drucker Bearing of risk, is the essential element of the business risk. Future is uncertain, and the business 194

2 activities are done for future, therefore, nobody can escape from the future risks. 2) Fundamental causes of risks are uncertainties: All the business risks arise due to human uncertainties, natural uncertainties and professional uncertainties. Changes in production, distribution, fluctuation in the price levels, structural changes in the Government policies are the examples of professional uncertainties. 3) Profit is the reward for bearing risks. It is often said that where there is risk, there is a profit. The business of high risks results in higher profits. 4) Degree and depth of risks varies with the size of the firm. The size of the business regulate the degree of risks, while the bigger transactions may have higher degree of risks. 5) Degree of risks varies with time: The degree of risks affected by equilibrium is demand and supply. If there are more disturbances in the country, the risks will be more, but during peaceful days the risks may be minimum. 6) Risks changes according to the nature of business. Risks on the commodities of fixed demand remains constant, but on fashionable items the business risks are more. 7) Degree of monopoly affects the business risk. A monopolist feels the minimum risk, but in competitive business, the degree of risk is higher. 8) Avoidance of risks may also become risk. Often it happens that a trader wants to minimize his risk and he makes certain efforts in this direction, but 195

3 on the contrary his business risks are increased. A trader reduces the price of his commodities with an expectation that the other trader will also reduce, but others not do so, therefore, his profits are unnecessarily reduced. An experienced businessmen may make necessary efforts affect the study of the business changes, and can keep remedial steps ready with him to overcome the difficulties of the business. Keeping the importance and the nature of business risk in view, this chapter is developed to bring an analysis of risk categorizing into its varieties and their respective impact and relationship with Economic Value Added (EVA) which is the modern and improved metric of business performance of select cement companies in India. Therefore, this chapter is organized to show in the first analysis relating to risk and in later its impact on Economic value deed through the new concept called EVA per unit of risk (EVAPUR) and relationship with EVA. Risk nourishes business but it could also kill it. There can be no business without risk. It is the wealth that come from taking risk that keep the spirit of entrepreneurship alive and business going while it encourages and tempts business to take risk. It is the not managed properly it could just wipe out the company. Therefore, it would be very pertinent to understand what is the amount of operating risk, financial risk and also the total business risk of select cement companies. The business risk has two components which are as follows: 196

4 1) Operating Risk. 2) Financial Risk. 1) Operating Risk: Theoretically speaking operating risk is the capacity of the respective cement company to use fixed operating costs consisting of land, plant, machinery, building etc., to magnify the effect of change in sales on the operating earnings called EBIT (Earnings Before Interest and Taxes). This can be calculated in the following manner. Or Where, DOL = Degree of operating leverage S = Sales Revenue V = Variable cost EBIT = Earnings Before Interest and Taxes. Higher the degree of operating leverage, higher will be the operating risk and lower the degree of operating leverage, lower will be the operating risk. Operating risk of select cement companies in India for the study period is shown below in the table No

5 Table-5.1 Showing Operating Risk of Select Companies in India for the ACC Study Period to Ambuja Birla JK s Madras/ Ramco Shree Ultratech Average Source: Annual Reports of the select cement companies. Graph-5.1 Showing Operating Risk of Select Companies in India for the Study Period to ACC Ambuja Birla JK s Madras/ Ramco Shree Ultratech From the above table it is clear that all companies have exhibited on an average a range of 1.1 to 2.05 degree of operating leverage for the study period. Among all the companies Shree s company is showing highest operating risk, whereas, Birla Company has got less amount of operating risk. 198

6 This signifies small jump in sales will lead to big jump in operating profit for Shree Company. On the other hand, a small fall will lead to big fall in operating profit. Therefore, Shree cement is risky company operationally it is very contra to Birla s and other companies. 2) Financial Risk: Another very important business risk of cement companies is financial risk which can be measure with the employment of degree of financial leverage. To define conceptually, it is the capacity of a firm to use fixed financial costs such as interest on debt, preference dividend on shares to magnify the effect of change in operating earnings called EBIT on earnings available to shareholders which usually will be in earnings per share form. It can be computed either of the following methods. (EBIT) Or Where, DFL = EBIT = EBT = Degree of financial leverage. Earnings before interest and taxes. Earnings before the payment of taxes. 199

7 Higher financial leverage degree would indicate higher amount of financial risk to the concerned company and vice-versa. Financial risk depends upon factors like operating earnings, capital structure, level of taxes and number of shares outstanding which it mean control of equity. Usually higher employment of debt lead to more risk. Company having high risk has more capacity to magnify the earning per share with a small jump in operating earnings, will lead to big jump in EPS Reverse will be case for company having low risk. Hence, table No. 5.2 brings the financial risk of select cement companies. Table-5.2 Showing Degree of Financial Leverage of Select Companies to ACC Indicate Financial Risk for the study period Ambuja Birla JK s Madras/ Ramco Shree Ultratech Average By the observation of the above table reveals that the average degree of financial leverage is ranging from 1.02 to 1.50 for select cement companies for the study period. Out of these companies JK s, and shree cements are financially having higher risk compared to other firms in the industry. On the 200

8 other hand, Ambuja s and Birla s have got lower risk financially. Therefore, financially risky companies are advised to improve the sales and operating earnings so that they can bring more magnification on earnings per share. Graph-5.2 Showing Degree of Financial Leverage of Select Companies to Indicate Financial Risk for the study period ACC Ambuja Birla JK s Madras/ Ramco Shree Ultratech 3. BUSINESS RISK: Business is made up of operating risk and financial risk. Business is exposed to several risks. All risks hve been categorized broadly into risks relating to operations and risk relating to finance. hence, business risk consists of operating risk and financial risk. Manager of respective company has to manage both the risks in the proper way which goes to identification, measurement, selection and implementation and review of risks. So in nut 201

9 shell, entire amount of risks can be known through the employment of degree of combined leverage. Degree of combined leverage is nothing but it is a power of the respective company to use fixed costs consisting of fixed operating costs and fixed financial costs to magnify the effects of change in sales on earnings available to share holders. Factors influencing business risks are sales conditions, cost conditions, capital structure, level of taxes, management control etc., degree of combined leverage is calculated by multiplying operating leverage with financial leverage simply Table No. 5.3 given below exhibits the combined leverage indicating total business risk of select cement companies for the study period. Table-5.3 Degree of combined leverage of select cement companies ACC Ambuja Birla JK s Madras/ Ramco Shree Ultratech Average

10 Graph-5.3 Degree of combined leverage of select cement companies ACC Ambuja Birla JK s Madras/ Ramco Shree Ultratech A quick examination of the computed value of business risk reveals that Shree cement company and JK company are more risky respectively compared to other firms in the list. Ambuja, ACC and Ultratech companies are having less risk. Therefore, boom in economic conditions would lead to more profit to shree cements and JK s. On the other hand, recession in economic activities could contribute damage to the shree cements and JK s. Therefore, management of these two companies should be more careful in managing the risks. Proper understanding and management of business risk can go a long way in adding value to the shareholders. Now it is the time to know the impact of business risk on economic value added. In view of this economic value added per unit of risk (EVAPR) is calculated and analyzed. 203

11 4. ECONOMIC VALUE ADDED PER UNIT OF RISK (EVAPR) Human beings cannot be evaluated on any one measure. In selection interviews, an accountant will score based on her or his knowledge of accountancy, but the security guard will score on his muscles and moustache. Similarly, the relevance of Economic value added per unit of risk is context specific. Economic value per unit of risk is in this study is done using the relationship between economic value deed and the total business risk which is being measured by degree of combined leverage. The calculation of which is as follows: Where, EVAPR = Economic value added per unit and risk. EVA = Economic value added. DOL = Degree of operating leverage. Higher the economic value added per unit of risk better is the wealth creation operationally as well as financially. Lower the economic value added per unit of risk lower will be the wealth creation to shareholders because of poor management of risks. For the select cement companies economic value added per unit of risk is shown in table No

12 Table-5.4 Showing Economic Value Added. Per Unit of Risk of ACC for the EVA study period Business Risk EVAPUR Nil (-2.45) 1.24 NIL Ambuja (Continued) EVA Business Risk EVAPUR (In. Cr) Nil (-148) 1.10 NIL Birla (Continued) EVA Business Risk EVAPUR (In. Cr)

13 JK (Continued) EVA Business Risk EVAPUR (In. Cr) Madras/Ramco (Continued) EVA Business Risk EVAPUR (In. Cr) Shree (Continued) EVA Business Risk EVAPUR (In. Cr)

14 Ultratech (Continued) EVA Business Risk EVAPUR (In. Cr) By keenly observing the data present from the table No. 5.4 it was evident that decrease in risk in most of the cases has contributed an improvement in the EVA except ultratech cement. For instance, taking the case of shree cements when the degree of risk was 2.45 its EVA per unit of risk was 350 crore, when it has gone down to 1.39 and 1.81 respectively, economic value added per unit of risk went upto 377 and 635 crores from 350 crores on the other end, for the same company risk increased to 7.59 and to 2.61, EVAPUR gone down to 139 crore and to 302 crore respectively from 635 crores. Therefore, in absolute view, we can conclude the fact that, the degree of risk and economic value added has inverse relationship which we can mean higher the risk lower will be the wealth creation and vice-versa. Therefore from this we can recommend not only the concerned companies but also other companies to try their best to minimize risk of either operations or financial in improving the value creation. Hence, EVA is inversely driven by the quantum of risk that the company has. 207