This is the second in a series of three articles on risk and PE firms, this installment will deal with the definition of risk.
Once there is a clear definition of and means for identifying risk, it can be can be measured. Risk can be broken down into levels of degree along with the associated financial impact on a company.
To better measure and better understand risk as it is spread across an industry, benchmarking segments an industry into five threshold points; the bottom 10% and 25%, median, and top performing 25% and 10%. These levels help to define the how critical risk is and how a company is compared to its industry.
As illustrated below, a company’s comparative value using the current ratio is measured across the industry. Using the top 10% as the standard to measure against, in this case a value of 2.70, the company’s current ratio of 0.84 falls far below the median value for the bottom 10% of the industry.
Thus, the company’s current ratio of 0.84 could be considered critical and at a very high risk across the entire industry.
Gap analysis
Another method for measuring risk is to use gap analysis; as illustrated above the current ratio gap between the company and the top performing companies is 1.86. A very substantial gap that would warrants further analysis into the company.
Whether applied to financial ratios or KPIs, the greater the measured gap between the established standard and the company the higher the risk and the financial impact.
This analysis provides a more accurate measurement of a company’s financial health compared to just comparing against itself. From the gap analysis, a company can determine what is at risk, what risk is acceptable, what risk is an issue and is critical, requiring immediate action. It goes further by providing the financial cost of that risk along with the financial impact of reducing that risk
Again, using the top 10% of the industry as a standard, the example below illustrates the same company’s inventory age. At 132 days, the company’s inventory age is twice the median value found for the bottom performing 10% of the industry.
The company would need to reduce inventory by 68 days just to meet the median level of the bottom 10% and a total 117 days to perform at the top 10% of the industry. At this gap level the company has $4.1 million at risk in the liquidity or cash flow of the company.
Improve the decision process
With the availability of comparative data to measure risk, the management of risk becomes easier and uniform. Acceptable risk levels can be established along with their associated measuring points, adjusted as needed across different industries.
Decision thresholds running across areas of liquidity, asset efficiency, profitability, etc. can help reduce analytical time in looking at new deals as well as in portfolio company oversight.
A uniform approach to risk management can thereby be developed, thereby improving the decision process while improving the decision process,
Financial risk is often looked upon as the company’s credit worthiness. But financial risk can come in many forms: too much or too little inventory, falling profit margins, inadequate cashflow, or even an ill-informed business model.
To handle risk a standard should be used for both identifying and measuring.
Benchmarking uses a set of over 30 key financial ratios and KPIs that can be uniformly applied across a variety of industries. They define areas of risk across a company in areas of liquidity, profitability, asset efficiency, and sustainable growth. For example, current ratio, quick ratio, collection period and deferred payment period are used for measuring a company’s liquidity.
To identify risk some form of data standard must be used in which to measure against.
Analyzing a company’s year-over-year KPI, such as sales, is good for meeting corporate goals and objectives, but can be misleading in understanding and managing risk.
An accurate method for identifying risk is to look at data from the best performing companies within a company’s industry. This provided an unbiased, independent standard of excellence that is established by the market and company performance. The issue with privately held companies is where to find available competitors information.
Benchmarking provides the data for identifying the industry’s best-performers, their associated KPIs and financial ratios to establish these standards for identifying risk. Comparative benchmarking can ensure the risk standards are based on same size companies for true apples-to-apples risk analysis.
In summary, the second step in managing risk is to have a clear and concise means for measuring risk. Measuring across liquidity, asset efficiency, profitability and sustainable growth gives a clear picture of a company’s financial health. In the final risk article we’ll look at mitigating risk and the impact this can have in better understanding risk levels, the financial impact on a company and what is acceptable.