It is also sensible to be aware of and take into account the human dimension. People behave differently and inconsistently when making decisions involving risk. They may be exuberant or diffident, overconfident or overly concerned. Or they may simply overlook the issue of risk.

One important priority is to identify significant risks within and outside the organisation and allow these to inform decisions. This makes it easier to avoid unnecessary surprises. Examples of significant risks might be the loss of a major customer, the failure of a principal supplier or the appearance of a significant competitor.

Risk surrounds us all the time. As Harold Macmillan, a former British prime minister, once said: “To be alive at all involves some risk.” Some of the most common areas of risk affecting business are summarised in Table 11.1. It is valuable when attempting to identify risks to define the categories into which they fall. This allows for a more structured analysis and reduces the chances of risks being overlooked.

To this list should be added another, intangible category: the opportunity cost associated with risk. In other words, avoiding a risk may mean avoiding a potentially huge opportunity. There is a tendency for people to be too cautious and risk averse, even though they are often at their best when facing the pressure of risk or deciding to take a more audacious approach. It is also worth considering that sometimes the greatest risk of all is to do nothing.

The acceptance of risk is an integral part of business, as is the principle that the higher the risk, the higher the rate of return needs to be. The willingness to take risks of both a personal and a financial nature is one of the defining characteristics of the entrepreneurial decision-maker.

Interestingly, a 1999 study commissioned by PricewaterhouseCoopers concluded that whereas in continental Europe strategies are generally oriented towards avoiding and hedging risk, Anglo-American companies view risk as an opportunity, consciously accepting the responsibility of risk management as necessary to achieving their goals.

Successful decision-makers understand this. They take steps to ensure that the risks resulting from their decisions are measured, the likely consequences are clearly understood and the danger signals are identified. Avoidable risks are pinpointed and eliminated, and others are reduced. Such decision-makers also take a holistic view of risk, going beyond the direct financial perspective and actively managing risk as it affects the whole organisation.

Accepting that risks exist provides a starting point for other necessary actions. Foremost among these is the need to create the right climate for risk management. People should understand why control systems are needed. This requires communication and leadership so that standards and expectations are set and clearly understood.

Understanding where risks lie and what needs to be done to reduce risk is an important part of the process of financial decision-making. For example, you need to know not only where the break-even point is, but also how and when it will be reached.

Reducing business risks

Reducing the risk inherent in business decisions is rarely a linear process. Instead, it is best achieved by applying principles and techniques appropriate to the specific situation and risk. Several of these techniques are outlined below.

Do not ignore or underestimate the wider impact of a financial decision on other parts of the business. Avoid weak budgetary control Budgets are often used merely to assess performance, whereas their real value is as an active tool to inform financial decisions. Budgets should not be cut without giving sufficient thought to how this will affect other
decisions.

Understand the impact of cash flow

Issues of cash flow and the time value of money are often ignored by non-financial managers, to the detriment of the organisation. In the worst case, this may result in the business becoming insolvent.

Financial decisions affect everyone. They should not be left entirely to the “experts” in the finance department or among specialist advisers. Financial issues and techniques – such as dynamic cost management, the importance of cash flow and the time value of money – affect all managers with a financial responsibility and are influenced by everyone.

Make financial expertise widely available Every manager in the business should understand the importance of financial management for profitability and success. People need to feel ownership of their part of the process of financial control, to have the information and expertise to make the best financial decisions and to consider all relevant decisions from a financial perspective.

Discounted cash flow analysis is used to help value the potential of an organisation and in making other investment decisions. The discounted cash flow method assesses the projected stream of economic benefits (such as cash flow, net sale proceeds, value of intangible assets) and calculates the maximum investment that should be made. This is known as net present value analysis. It also enables comparison of an investment amount with a stream of economic benefits and provides an overall rate of return. This is known as internal rate of return analysis, enabling analysts to assess the rate of return provided by a particular investment. Many consider that discounted cash flow analysis is more useful than other valuation methods, such as price/earnings ratios. If an investment case is sound, then discounted cash flow will highlight this.

Decide the discount factor: the percentage that will be deducted from each year’s cash flow. Determining this is central to the whole exercise. A higher discount factor will generate a lower overall valuation. Typically, two things influence the level of the discount factor. The first is the level of business risk. If the risk is high (and the investment is unlikely to meet its projections), the discount factor should also be high. Second, there is often a compromise between the cost of borrowed money (such as 5% interest) and the return expected by the investors (for example, 15%); in this case, the discount factor would be 10%. It may be desirable to select a range of discount factors, providing optimistic, realistic and worst-case scenarios.

Apply the discount factor to the net cash flow for each year of the projection and to the terminal value. The figures resulting from these calculations are the present value contribution of each year’s future cash flow; adding these values provides a total estimate for the value of the investment.

Some investment promoters claim they have all this covered. They ask you a series of questions about your risk tolerance before they sell you their products:

“If the market declines 25 percent in one year, will you take your money out?” _ “Are you able to keep the long-term in mind when markets fluctuate or are you more comfortable with investments that do not fluctuate?” These tests determine your so-called “risk tolerance.” Risk tolerance is your ability to handle volatility. Risk tolerance tests are supposed to match you to compatible investments. Unfortunately, they don’t.

Risk tolerance is not a good measure of investment compatibility. At best, it measures a narrow aspect of your personality: your theoretical ability to handle volatility. Even if your broker happens to sell the product that is theoretically right for your risk profile and you buy it, studies show that how people think they will react under adverse market conditions and how they actually react are quite different. In fact, few of us know ourselves well enough to know how we would really react in future unknown situations.

In the runaway real estate market, adjustable-rate mortgages were everyone’s best friend. With interest rates that were significantly lower than fixed-rate mortgages, homebuyers could purchase a larger and more expensive home for the same payment as a fixed-rate mortgage. Mortgage brokers and real estate agents loved them because they could sell you a bigger house and earn a bigger commission.

Of course, there is just one small problem with adjustable-rate mortgages … they adjust! When the rate finally goes from 3–4% to 8–9%, your mortgage payment might double. That’s a huge adjustment for any budget—especially if you didn’t see it coming.

Adjustable-rate mortgages come in two primary types, all of which can leave a homeowner between a rock and a hard place:

Balloon mortgages. The monthly payment on these mortgages looks like a 30-year mortgage payment. However, a balloon mortgage requires the entire mortgage balance to be paid off after a short period of time, usually seven years.

7/1 or 5/1 mortgages. These mortgages have a lower rate for the first 7 or 5 years, after which the rate adjusts every year for the remaining 23 to 25 years of the loan!

Though the statistics vary by study, it’s estimated that one quarter to one third of all home purchases are made with adjustable-rate mortgages. In the beginning, adjustable-rate mortgages were designed for people who thought interest rates were going to go down within a few years of purchasing a home, or those who thought they would move within 5 to 7 years. Someone in either of these situations would benefit by not being locked into a longer 30-year fixed-rate mortgage.

If you plan on being in your current home for more than 5 to 7 years, or you think interest rates will stay the same or climb, you need to think about getting a better loan.

Once upon a time, a fixed-rate mortgage was the only real option. It may have taken some folks a few years to get to the point where they could qualify for one, but once they did, they were in a good, predictable situation.

In essence, a fixed-rate mortgage has one interest rate for the entire life of the loan. While this interest rate may not be as low as the adjustable-rate mortgages that have contributed to the housing crisis, it’s predictable. Owners are not likely to be caught off guard.

Most fixed-rate mortgages have either 15- or 30-year terms, but are often “refinanced” or replaced, with other fixed-rate mortgages when interest rates decline. It’s likely that homeowners will need to try and convert their adjustable-rate mortgages into a fixed-rate mortgage. That stability is key to diverting money to take care of other kinds of debt.