Introduction
Risk occurs when the economic outcome expected differ from the actual outcome. In most companies, risk relies on random variables which determine the company profit and loses. There are different types of risks which companies face. Financial risks are the risks which involve financial implications of a company. However, most of the financial risks are indirectly related to the financial performance of a company. Non-financial risks are those risks which come from external sources. They include government regulations, price risks, human risks, and production risks. Additionally, there are static and dynamic risks. Dynamic risks results from the changes in the economic environment such as the development of new technologies, change in institutional regulations, or even changes in customers taste. The society is usually the beneficially of the dynamic risks because the lifestyle of customers is changed and they have new ways of doing business at lower costs. Fundamental and particular risks, on the other hand, are those risks which affect a large group of companies and are usually out of individual’s control. They are therefore considered social imperative and they include unemployment, natural disasters, and even terrorist attacks. Particular risks can be avoided by registering companies to private insurance but not the fundamental risks.
The pure and speculative risk is another source of risk. Pure risks involve loses only and they include car accidents, medical risks, and deaths. Speculative risks involve gains and losses. They are mainly evident in gambling. However, pure risks can be insured though they are of different categories. Personal risk is an example of pure risk where there may be premature death, sickness and disability and even unemployment. Property risk, on the other hand, involves losses that can come from the direct loss of products or theft. Liability risks take the course when somebody commits a violation against another and the person is held liable for the damage caused. Risks from failures of others include failure to make payment as promised.
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Risk Sources
Company’s like Coca-Cola face risks which may be from the following sources. Financial risk and market price. This type of risk emerges when the price of commodities change in the market and the company cannot have control over the situation. However, monopolistic companies are not faced with this type of risk because they can set prices of their own products. This type of risk affects the price takers who have no influence over the price of commodities and have to take the price that emerges from the market equilibrium. Production can be another source of risk. The challenges a firm faces in their day to day operation can greatly affect the bottom-line profit margin. Such kind of risks can be handled through company’s marketing and product development strategies such as advertisements, the formation of alliances, managing the supply chain, and retail and distribution. The aim of these activities is usually to improve the profit margins. The main sources of production risks include entry of a rival in the market, market demand, and product lifecycle risks, weather and climatic changes, competition, pests and risks from various biological sources.
Finance is another source of risk in Coca-Cola especially debts. Debt gives the external body an opportunity to force a firm into bankruptcy especially when a firm is unable to pay its interests payments. Increase in the interest’s rates also limits the ability of firms to raise their debts and equity capital. Institutional risks emerge when government’s changes policies and regulations from time to time. Change in government regulations has financial impacts on the way firms run and the amount of profit they can make. An example, when government regulates food safety standards, pesticide registrations income policies and trade agreements with potential importers, the agribusiness sector is usually adversely affected. Human and personal risks play a direct role in the fluctuations of the financial performance of a company. The best way of handling this type of risk is having a proper recruitment program, providing healthy working conditions so that employee commitment can be enhanced. Most firms have corporate cultures which favor productivity from workers though it does not work in some firms. An example of human risk is director and officer risk because decisions from the corporate directors can harm many people who work in a firm. In most cases, firms buy insurance covers for director and officer risks. Business and strategic risks emerge when a competitor cuts his price, develops new products, increases advertisements and steals key personnel, then, the sales of firm products are likely to be adversely affected. Firm’s reputation to customers can be ruined by increased competition from other companies.
Risks Extent
Risks depend on the type of industry and the attributes of the individual firm or company. However, some of the risks are more volatile and have more serious adverse effects than others. Here are some of the risks.
General Price level risk. Price of commodities is usually measured by consumer price index. Consumer price index holds goods that are used regularly such as food, shelter, transportation, insurance services healthcare and even education. Each commodity in the CPI is weighed by the Bureau of Labor Statistics by surveying households on regular basis. The general trend growth rate in the CPI is what is referred as inflation. Therefore, the rate of inflation in CPI tends to overstate the true rate of inflation mainly because of two reasons. First, food and energy prices tend to be more volatile than the cost of living and secondly, it does not give allowance for the fact that consumers readjust the mix of products they purchase as relative price change in order to minimize the cost of all the products they purchase. An example, if there is an increase in beef price in relation to pork, the CPI continues to assume the level of purchase by the consumers is usually the same ( Houdet, Trommetter & Weber, 2012). The CPI is usually wrong because, in a situation like that, consumers will reduce the amount of beef they purchase and instead increase the purchase for pork.
Exchange rate risk is another risk that is volatile. It poses significant financial risks for multi-national firms such as Coca-Cola that either export or import goods to and from abroad. Additionally, firms in foreign countries are greatly affected ( Gates, et al., 2012) Firms like Coca-Cola usually experience transaction risks as the foreign currency price of the goods they sell and buy fluctuates with the rates of exchanges. The Coca-Cola Company must convert foreign profits back to American dollar for reporting purposes to shareholders and financial markets. Comparing the volatility of the American dollar to other currencies, the coefficient of variation of the American dollar exchange rate with several major currencies can be calculated. The least volatile exchange rate is the US/Canadian rate which has a coefficient variation of 0.13, US/Japanese yen with a coefficient variation of 0.39 and so forth ( Houdet, Trommetter & Weber, 2012 ). The change in the coefficient variation reflects the fundamental differences in the economic cycles followed in countries where the company has invested.
Interest rate risks can also be volatile in the current markets. The volatility of interest rate is important for the Coca-Cola Company because it influences firm value in three ways. First, increase the interest rates causes a rise in debt financing. Secondly, high-interest rates slow down the pace of economic activity and lastly, increase the rates of interest increases the discount rate which investors use to value financing assets such as the stocks of the publicly traded company ( Houdet, Trommetter & Weber, 2012 ). Therefore, Coca-Cola investing in countries whose interest rates are stable, there is the likelihood of more investments and attraction of higher valuations from the public than would otherwise be the case.
The commodity price risk is another type of risk that is faced with volatilization. Most firms, including Coca-Cola, receive the prices of their commodities depending entirely on competitive world markets as they have no way of differentiating their products from the products of other companies. For instance, those firms which sell agricultural products, copper, oil, and even lumber are usually subjected to commodity price risks that are beyond their control. Other firms which use commodities as inputs are also subjected to this type of risk in terms of their production cost rather than their topline revenue. Operating and production risks are sources of financial risks which arise from market transactions. Ricks from non-financial sources can also materially the probability that the manager will not be able to achieve the financial goals set by a company. Most of the insurance companies are designed to allow producers and their managers offset this kind of risk.
Risk Management
These are practices and activities that are designed to prevent the impact of risks on the financial outcomes of a firm. The simplest method of preventing economic risk is maintaining a capital reserve which is used to protect loss of the shareholder wealth in case of an adverse event or set of adverse situations. The capital reserves are costly but they represent funds which earn no profits from elsewhere. There are several ways of responding to risks.
Avoiding the risk. If the project or activity proposed has a probability of recording losses, the firm can avoid the project entirely. This is one of the methods used by the Coca-Cola Company. The approach arises out of highly adverse behavior and it means that the company misses many potential profitable opportunities. Secondly, the risk can be assumed. In most cases, risks are assumed because companies are ignorant or have no ways of dealing with the risk. Firms can also assume the risk because they are risk loving and they see increased potential for profit in investing in such projects. Also, risks can be transferred by selling insurance. In the transaction, the party which assumes the risk will be compensated in order to agree to remove the risk that faces the other party. The r isk is also shared where firms form partnerships ( Houdet et al., 2012) . Additionally, possibilities of risks can be reduced through risk prevention activities such as training, enterprise diversification, geographical diversification, and management training. The risk management processes can be consulted to assist in preventing certain risks from occurring. However, risk management program is developed adhering to the formalized process of Enterprise Risk Management.
Risk Management Products and Practices
Risk reduction strategies involve practices and transactions of a wide range. Some of the strategies are defined on balance sheets such as choosing to invest in projects that are less risky, buying insurance policies while other strategies are off the balance sheet such as all future options, swaps, and forward contracts. The choice of the tool used depends on the type of business a firm is in, the source of the risk faced, shareholders, attitudes the business has towards an assumed risk, the cost of the strategy taken and the opportunities that are available. In most situations, companies don’t have insurance policies to help them manage a particular type of risk. Here are methods used by firms such as Coca-Cola in managing risks.
Enterprise diversification. This is a very fundamental way of reducing the effects of any source of volatility to develop a business model where profits are derived from different types of sources. If profits from any of these sources are incorrectly correlated, then the overall variability of profit for the whole firm will be less if the firm operated on one sector of the economy. For instance, Coca-Cola invests in many countries to ensure the sources of profits are from a varied number of sources.
Geographic diversification. Geographic factors face firms that are involved in primary production such as farming firms. Such firms can diversify by operating in different regions. Additionally, for companies with significant international exposure such as Coca-Cola , most of their profits are from international operations. Diversification in different countries reduces the risks of an economic downturn which can affect the firm’s key markets at once.
Firms can also have insurance contracts with insurance companies. For instance, Coca-Cola can purchase insurance contract which provides compensation in case of losses. The losses which insurance companies compensate are those which are catastrophic in nature such as natural disasters, accident, death and floods rather than losses caused by day-to-day market variability. Contract production is another way of reducing risks where suppliers seek assurances of future sales and volumes by signing long-term supply contracts ( Frigo & Læssøe, 2012) Debt management is also used by companies and firms to reduce possible risks in future. The total leverage measures impact both business and the financial risk that faces a firm. Because the risk of debt derives from both sources, managers can offset one source of the risk by decreasing the amount of risk that comes from the other. The situation makes a firm a volatile business in production and in its operating sense. Therefore meaning the firm should use very little debt and rely on equity financing.
Enterprise Risk Management
There have been different approaches to managing risks based on the fact that the only risk that matters is variability in the shareholder value. The causes of variation in shareholder value are not independent of one another but instead, they are much linked. Each of these risks has a likelihood of having the same impact on the firms because each of them will cause variation in the net income in some way or another ( Gates, Nicolas & Walker, 2012). There is a sense to design programs and strategies that use this interdependence to more efficiently and effectively limit the amount of financial damage that the risks can have on a firm basing the fact that the risks are related in terms of their source and outcome. This perspective also helps build an organization-wide appreciation for the different sources of risk that a firm faces and allows different functions to understand how another can help absorb or offset the risks that they face. Thus was born “integrated risk management,” “business risk management,” or “enterprise risk management (ERM).”
ERM Process
ERM is not one tool but a description of the entire approach that is used in managing risks. The process consists of five major steps;
First, is determining the objectives of the risks. This step occurs before any other decision is taken so that an effective and successive risk management program can be arrived at. The objectives of the risks must be clearly written down and communicated through the entire firm. The aim of the risk management program should be preserving the financial viability of the firm so that the risk does not become a hindrance to the profitable operation of the firm as a whole. Identification of the risk is the second process where the organization is required to go through analysis and cooperation of all parts of the firm ( Frigo & Læssøe, 2012). Statistical analysis of the relationship between various risks and financial performance should be a key part of any risk assessment program. Data for such analyses can come from many sources which include , internal financial statements, interviews with employees, senior managers or investment analysts, broad surveys administered to all employees, or public financial records and stock market data. The goal at this stage should be the identification of factors that have the greatest potential to cause the firm to fail to miss its financial objectives on an expected-value basis. Risks at this stage can be both discrete and continuous. The risk is identified whether it is a market risk, financial risk, human risk, policy risk, business risk or strategic risk.
The risk is then measured. There are many ways of quantifying a risk depending on the specific risk concept that the firm has in mind. Some of the measures which may apply in different situations include historical volatility which is determined in terms of the probability distribution of historical shareholder returns. The returns are defined as the rate of price appreciation plus the dividends of the shareholders ( Frigo & Læssøe, 2012). A more relevant measure can be calculated with a coefficient of variations which is usually the ratio of the standard deviation to the mean of returns. Also, risk can be measured in terms of expected utility, value at risk, and factor models.
The fourth step of ERM involves responding to the risk. In this step, an appropriate program is developed to respond to the various risks which are faced by the firm. It has to be recognized that the risks may be interdependent. Risk can be responded via three methods which are either through assuming the risk, controlling the risk or transferring the risk. In risk assumption, there is nothing done if the costs of controlling the risks are higher than to execute the risk. However, assuming the risk means absorbing the resulting loss of internal capital. In controlling the risk, the process can be done either by diversifying the business, adopting insurance programs that are safe or financial reconstructing. Each of these responses to risk is not an attempt to shift or paste over the cause of volatility ( Gates, Nicolas & Walker, 2012 ). Transferring the risk, on the other hand, involves paying someone else to accept the risk. The process may involve insurance companies or other forms of contingent capital such as income-stream securitization are all means of moving your risk to someone else at a cost.
Risk interrogation is the final step and it entails how the program is to be implemented in the firm. Interrogating the risk involves several steps which include . Implementation, monitoring, and feedback. In the implementation stage, vesting sufficient oversight and control with one individual such that no risk management activities can be undertaken without someone higher in the organization’s knowledge ( Gates, Nicolas & Walker, 2012 ). Reporting and sharing of information should be made sufficiently explicit that decisions are not taken in a vacuum, yet not so burdensome as to prevent managers from making decisions in real time. Responding to the need to view risk with an organization-wide perspective, many firms have created the position of Chief Risk Officer (CRO) who answers only to the board of directors. Independence from the financial operation of the firm allows the CRO to view production, human and market risks in a more holistic sense. In monitoring, evaluating and review stage, the risk management program is subjected to review at least twice a year ( Hallowell, et al., 2012) In this process, the managers involved should realize that changes in the state of the world occur with regards to markets, technology, competitors or risk management products, and secondly, mistakes can and do occur if the program is designed to be flexible enough to allow for individual input and decision making. The trade applied is usually control versus efficiency –effectiveness and is usually not the same as zero exposure at film level.
In the feedback stage, effective and continuous feedback needs to be put in place to ensure flexibility is put into practice. If the review and evaluation process finds that the ERM program is not fulfilling its intended goals, the program needs to be changed. The change should not be tabled in terms of failure, blame or finger pointing but rather, it should be couched in terms of recognition of the need for an inherently dynamic process to evolve as people, ideas and circumstances change.
Benefits of ERM
When firms implement their ERM program efficiently, there are many benefits that are achieved. Coca-Cola has had a lot of benefits which include financial and economic benefits which involve preservation of the firm’s capital. Ricks is not actively managed but rather accommodated by absorbing financial shocks while cash is at hand. The process helps in preventing any liquidity that may result from unexpected loss or reduction in earnings. Secondly, debt capacity is increased, reduced cost of capital, the downside risk is also reduced, the cost of risk is also reduced, and limitations of earnings volatility are removed. Organizational benefits are also achieved where people from different departments are brought together to share information on the risks their firm is facing and the potential strategies of removing the risks. Additionally, the firm learns how to use the risks it faces and turn them into means of maintaining a competitive advantage. Lastly, ERM helps firms to avoid redundancy.
Conclusion
Every firm has to face risks and uncertainties in its day to day operations. Therefore, the firms must develop ways and strategies of handling and deal with these risks they face. In most cases, firms do not actively manage risks. They, therefore, have to develop ERM programs which they will use to deal with the risks they face. ERM programs have vast advantages because they enable a firm to be united in finding means of dealing with their situations. Additionally, the best method of dealing with the risk is adopted where some risks are turned into firm’s way of maintaining a competitive advantage.
References
Frigo, M. L., & Læssøe, H. (2012). Strategic risk management at the Lego Group. Strategic Finance , 93 (8), 27-35.
Gates, S., Nicolas, J. L., & Walker, P. L. (2012). Enterprise risk management: A process for enhanced management and improved performance. Management accounting quarterly , 13 (3), 28-38.
Hallowell, M. R., Molenaar, K. R., & Fortunato III, B. R. (2012). Enterprise risk management strategies for state departments of transportation. Journal of Management in Engineering , 29 (2), 114-121.
Houdet, J., Trommetter, M., & Weber, J. (2012). Understanding changes in business strategies regarding biodiversity and ecosystem services. Ecological Economics , 73 , 37-46.
https://coca-colahellenic.com/en/about-us/business-resilience-and-risk-management/risk-management-process/
https://coca-colahellenic.com/media/2596/business-resilience.pdf .
