Unit IV

Fundamental Organizational Level risks Analyst Perspective

Topic: External Risks

These are reference notes only, should not be construed as complete text for the above topic.
Students are expected to do further research and extrapolate the points mentioned. They need to
identify/create suitable examples for the given notes and get them verified.

Across the world, strong companies and enterprises have floundered because of inadequate attention to
external threats. External risks are the first among the three major operating risks. It refers to all those nonindustry and non-entity factors that impact the operational and financial aspects of business.
Businesses do not operate in a vacuum. Many external factors do influence the results actions and
decisions of businesses, although diverse businesses are impacted by varied external factors in dissimilar
ways. While a government contractor may face a difficult situation because of settlement of dues by the
government, a restaurant chain will not be affected to the same extent. The real world is full of political,
social, technological and other forces, which intermix and sometimes flow at cross currents. Identification of
the major external risks and awareness about how major external variables impact the performance of the
obligor is crucial for good business/financial/credit risk analysis. Following are the 12 major sources of
possible external risks that can give rise to a worrisome situation for a business entity.
1. Business Cycle:
An economy, even though how well-managed, is not static, and undergoes different periods or stages of
economic growth widely known as business cycle. It is now considered an integral part of a dynamic
economic system largely capitalist in nature. It cannot be eliminated. But policy makers, with
indispensable aid of economists, have done much to tame the viciousness of downturns over the past
50 years. The economy goes through different stages recession, trough, recovery and peak. These
are explained below.
Recession: in this stage of the cycle, economy activities slow down with rising unemployment,
slowing sales and reducing corporate profits,. Inflation and interest rates ought to have already risen
(usually not always) with business spending down and businessmen and corporate executives
worrying about how to cut costs. Given the overall weakness, the investments get curtailed.
Bankruptcies increase as weaker firms find it difficult to cope. All responsible governments try to
meet the recessionary tendencies of the economy well in advance with appropriate monetary and
fiscal actions. It is widely held view that if the economic growth is negative in two quarters, the
economy is in recession.

Trough: things look like they are at their worst. High levels of unemployment, general gloom, lowest
production levels in the recent history of the economy, bottomed stock market and bankruptcies of
bank and other financial intermediaries due to heavy bad loans are some of the symptoms. There is
a feeling that things cannot go further worse. Again this phase can be shortened by appropriate
actions by governments, either with or without the help of multilateral organizations.

Recovery: Things begin to look a little better, with business confidence returning and economic
activity picking up. Stock prices and employment levels start rising while investments and profit
increase. In the first half of an expansion, it appears that the profits will rise faster than wage
because of increasing productivity. Periodicals (monthly / quarterly, etc.) related to economy are full
of good news, reporting higher manufacturing growth, tertiary growth, less unemployment, less
inventory level, more factory orders, and so on.

Peak: The economy puts up very strong performances with low unemployment levels. Markets get
heated up with price levels under pressure. Euphoric conditions prevail. Consumers over-extend
their credit and spend heavily, assuming steady future cash flows. Business magazines roar with
positive headlines and many proponents emerge arguing that this time (peak period) things are
different because of technology or otherwise and predict long-term further growth. Overconfident
investments ventures are undertaken, creating overcapacity, bordering on high risk/low return

business decisions. Non vigilant financial intermediaries are also pulled into supporting these
ventures. The ecstasy continues till a shock sets in, triggering a financial crisis culminating in a
recession.

Benefits of Study of Business Cycles: Analyst should focus on the extent of the impact of
business cycles on obligors and assess their strengths to overcome the negative influences of
cycles.
The study of business cycles is a powerful tool in the hands the finance / credit executives. During
recovery time, additional investments stimulate a lot of economic variables such as additional
employment, demand for finance, creation of new assets and so on. On the other hand, in a
recession situation the business confidence erodes, resulting in poor performance of most business
entities, impacting the financial/credit risks adversely. While most of the businesses do well in the
economic growth (which can be linked to the recovery and boom phase in a business cycle),
economic decline (recession / trough in the cycle) causes bankruptcies and credit losses. The
majority of the business firms tend to do poorly in recession. Probably the only ones who thrive in a
recession are scrap metal dealers and bankruptcy lawyers.

2. Economic Conditions:
Changes in economy impact entire constituents, albeit in varying degrees. A growing economy with
increased spending by consumers will result in accelerating demand; in turn encourage production
expansion, creating more demand for factors of production, improving overall employment resources.
While analyst need not be an economist, grasp of a few economic fundamentals are essential. One of
the best ways to understand an economy is to study the national income (NI) or gross national product
(GNP), usually expressed as:
Y = C + I + G + (X M), Where
Y = National Income
C = Consumption
I = Investment
G = Government spending
X = Exports
M = Imports

Private Consumption: this is the largest component in most economies. In India it accounts for
about 2/3rds of the economic activity, which is true of most other economies too, including the largest
economy, the USA. Private consumption broadly includes all types of goods consumed by general
population ranging from foodstuff, clothes, cars, washing machines, home computers, cosmetics,
school items and kitchen utensils to costly interior decoration materials. Hence, changes in private
consumption will definitely impact businesses and hence is a risk in itself.
Given its importance, all responsible governments actively encourage the development of various
types of consumer goods and expansion of the consumer market, though the budget and various
other fiscal / monetary policies. Taxation policy, future expectations, income level and equality of
income distribution are some of the factors influencing private consumption. Higher taxation and high
levels of inequality are generally seen as suppressant of private consumption, while higher future
expectations and income levels are considered triggers for enhancing consumption.

Government Spending: Governments spend not only on providing basic services such as law and
order, defence and social welfare activities, but also endeavour to implement various infrastructure
projects. Governments are usually concerned with agriculture, water conservancy,
telecommunication, power and so on. While changes in government spending directly impact certain
sectors such as government contractors, the overall impact is felt throughout the economy.

Investment: This is one of the key economic activities in any nation undertaken by both the private
and public sector. Investment is usually done out of savings by various economic agents. When an

economy cannot save cannot save enough to meet its various investment needs, it should seek
foreign investment or development assistance from multilateral agencies such as the World Bank
and Asian Development Bank .if the gap between investment and savings is funded through foreign
borrowings, it casts obligations on the borrower whether private sector and government to
service on the debt schedule.

Imports & Exports: international trade offers each country the benefit of specializing in production
of goods in which it has comparative advantage and then exchanging them for something in which it
has comparative disadvantage. Unless carefully managed, the changes herein can lead to foreign
exchange problems, triggering economic crisis.
National income (NI) statistics are important for understanding the operating risks facing the
business concern. An analyst should attempt to identify the contribution of the particular business
segment in which that firm operates, to the overall economy. For instance, a company engaged in
the production of some kind of building materials, it is imperative to look at the contributions of the
construction sector to the overall economy and the rate of growth in the past and that predicted in
the future.

Another way to look at NI figures is to determine the general direction in which the economy is
moving. For instance, if there is heavy investment taking place in the economy, it may indicate
higher industrial activity in the future either for internal consumption or for exports, which will have a
boom effect in the economy.
Benefits of study of National Income: Study of NI components and linking them to the business
entity, brings out relationships highly useful to evaluate the credit risks involved. Following are the
two important firm-level variables influenced by economic conditions:
Revenue: Improving consumption under economic growth will result in the increase in
consumer goods, resulting in higher sales for the firms, products and services. This in turn
will trigger demand for the intermediate and basic components essential for production of
consumer goods. Overall, the sales revenue will increase translating into more profits for the
businesses. On the other hand an economic recession or trough, the spending levels will
touch lower levels because of lower sales, which will lead to collapse of weak businesses
those with internal flaws or bad structures.
Business Confidence: If the demand continues to be strong and outstrip the current
production level, business people may decide to expand their activities. Additional
investments stimulate a lot of economic variables such as additional employment, demand for
finance and creation of new assets. Higher level of investment activities brings in several
advantages to the economy. On the other hand, in a recession situation the business
confidence slips, resulting in the cancellation of projects, which not only affects the individual
firms profitability but impacts the overall economy also.
Economic growth is defined as the rate of change in national income. NI can also be divided into 3
sectors primary, secondary and tertiary. Per capita income is obtained by dividing the NI by the
population. Increase in per capita income is the most commonly adopted measurement for gauging
the standard of living. An in-depth study of these economic aspects is beneficial, which is why many
companies having sizable credit portfolios appoint full-time economists on their payroll, who are
primarily focused to identify and warn about any impending dangers seen across the zone. In the
absence of the support of an internal economist, credit risk professionals should depend on external
sources, which should be vetted with the care necessary while relying on secondary sources.

3. Inflation/Deflation:
Changes in inflation, the term used to denote persistent increase in prices and measured by the
consumer price index (CPI) and the wholesale price index (WPI), is another trigger of external risks. Low
levels of inflation, say around 5% are considered as normal and good for businesses as they can lead
to short term gains viz., they can earn more profits. Higher levels of inflation will result in economic
problems, while hyper-inflation (above 50%) will lead to greater problems. It is to be noted that sudden
increases in money supply, if not matched by a similar increase in goods and services, lead to inflation.

Sudden increase in demand or costs, supply shocks, deficit financing and future expectations are some
of the other factors that result in imbalance in supply of goods and money.
A credit executive, a banker, or an analyst cannot ignore the inflationary risk exposure of the obligor,
mainly because of the following:
Higher levels of inflation will persuade the central bank of the country to increase rates, which
usually will while other things remain the same impact foreign exchange rates. Hence, a
customer having substantial foreign exchange exposure is likely to be impacted accordingly.
Higher interest rates will sharply eat into profitability of a business relying on leverage. If a company
is in a weak financial with high operating risks or having internal structural defects, adverse credit
risk migration is a highly likely scenario.
Government attempts to reduce the inflationary pressure not just by controlling money supply but
also through increasing taxation and reducing own expenditure.
Higher levels of inflation will render domestic goods uncompetitive, which may lead to lower exports.
4. Balance of Payments and Exchange Rates:
The impact of imports and exports and the other foreign transactions such as investment flows and
services are captured by the term, balance of payments. It measures how much a country has to pay to
the rest of the world or vice versa. It is usually smaller and consists of purchase/sale of assets, loan /
gold transactions, investments, repatriation of capital dividends and foreign aid, among others. Current
account, which is the largest component, comprises the trade in goods and services, reputation of the
employee compensation, gifts, and donations and so on. Risk lies in the management of balance of
payments by governments, and it has a close link with foreign currency rates. This brings in another risk
volatility in foreign currency rates, which may be either fixed or floating. While in the case of floating
exchange rates, the demand and supply of a currency determines the exchange rates, fixed rates are
not allowed to move freely to the markets whims and fancies.
While the risk emanating from adverse balance of payments and resultant movements in foreign
currency rates is systematic in nature, not all businesses are affected to the same extent. If the demand
is price inelastic, the quantity sold will almost remain the same despite foreign exchange fluctuations,
while in the case of price elastic business, the impact will be greater. Generally, the impact of
devaluation or appreciation has following effect on the businesses:
Devaluation:
Appreciation:

Exports are incentivized

Exports become costly

Imports become dearer

Imports become cheaper

It is the strategy of some export-oriented countries to devalue (or keep devalued) their currencies to sell
more in overseas markets. In such instances, relevant monetary authorities sell locally whenever the
currency appreciates beyond a certain level. Currency devaluation of competing nations can impact
domestic industry. However, as the new equilibrium sets in with adjustments to the economy and other
macro variables, life (business activities) will go on. An analyst is more interested in understanding how
life will be after the new equilibrium.
5. Political:
Business is impacted by political developments regionally, nationally, and internationally. Some of the
business risks directly emanating from political factors are confiscation, currency repatriation restrictions,
limits to business transactions, and legal controls. Political stability is highly rated for attracting foreign
business investments. The second type of political risk is not directly linked to government actions but to
political events caused by other vested interest such as, violence, terrorism, riots, guerrilla/civil wars
bandhs, strike, lockouts etc. There are number of political events and constraints, which will eventually
cause or harm to a business operating in a foreign environment. Uncertainty in political situations will
dampen investments and other spending, which in turn has its own economic consequences.
6. Fiscal policy:
The government uses fiscal tools such as direct and indirect taxation, surcharges, disinvestments,
levies, duties and tariffs to raise government revenue, while government spending includes both routine

and planned/unplanned expenditures. The manner in which the Government decides to raise resources
and spend has business risk implications. Business risks emanating from both direct and indirect fiscal
policies can sometimes be quite significant. For instance, if income-tax levels are increased, the disposal
income will be lower, impacting certain categories mostly luxury or durable goods of businesses.
Lowering of import tariffs, due to globalization pressure or otherwise, is yet another instance of business
risk emerging from fiscal measures.
7. Monetary Policy:
The government usually through the Central Bank of the nation, attempts to control the money supply in
the economy to achieve various goals such as stability in price levels and foreign exchange rates,
conducive economic atmosphere for growth, among others. Changes in interest rates, forex controls,
buying and selling of treasury securities are some of the main tools used by Central Banks to achieve
the desired money level in the economy. Interest rates are generally kept high to ward off inflationary
pressures or to neutralize higher demand or to attract foreign investments. However, high interest
regime is yet another risky period; as Demand falls as economic agents become reluctant to buy with
borrowings that result in higher expenses. While almost all businesses feel the impact, those which rely
on cheap financing such as instalment financers etc., may get a bigger jolt.
Interest rates have not only an operational angle, but a financial one as well. It should be noted that
when interest rates move from 5% to 7.5%, the rates have not only increased by 2.5%, but the additional
financial burden in absolute terms goes up by 50%! Awareness of the current monetary policies and
likelihood of its continuation, together with ability to gauge the impact on the businesses, enable analysts
to unearth some of the significant operating risks facing a borrower.
8. Demographic Factors:
Population structure & composition have immense significance for businesses because it determines
most of the ultimate market. Some of its main elements are outlined below:

Young generation with purchasing power means good times for youth-oriented businesses, including
sports cars, fancy two-wheelers, fashionable clothes, latest sportswear, shoes etc.
Ageing population on the other hand may require more health care and pension support.
Religion determines the festivals and ceremonies associated with it.
Similarly, ethnic mixes and their customs and celebrations provide unique business opportunities
The demand of the educated population differs from that of the uneducated, with the formers better
awareness translating into more demand, including that for knowledge-related items.
Working women in the population mean potential business for fast-cook, ready-to-eat items, timesaving household equipments etc.
Cultural Patterns determine dress codes, fashion, style, entertainment type and so on, and thus
influence the businesses.

9. Regulatory Framework:
The number of regulations imposed on business and penalties for non-compliance is another source of
potential operating risks. In order to carry on your business, you may require a lot of sanctions,
permissions, licences from a host of government agencies. Excessive regulations can dampen risktaking and encourage corrupt practices. A general look at the directions in which regulations are
operating can indicate the potential operating risks emanating there-from.
Additionally, a proper and effective legal system goes a long way in ensuring business confidence and
hence provides a suitable business environment where businesses can flourish. Absence of a good
legal system or inordinate delays in getting legal redressal are potential operating risks, especially if
significant disputes or legal issues threaten to emerge from business activities.
10. Technology:
One of the main features of the twentieth century was the vast new technologies developed, a trend
which is expected to be continued more voraciously in the 21st century as well. The cost of production
under current production technology may turn out to be more because the new technology may need

less inputs or lower process time resulting in lower cost of production or better quality products. Now-adays technology is considered a very vital source of operating risk and most of the project-financing
institutions insist on independent technology evaluation reports while assessing financing applications.
11. Union Involvement:
Establishing a union and negotiating/bargaining/striking etc. for improved employment conditions is an
accepted phenomenon most countries, with exception to few. Too much unionism disregarding business
realities is an operating risk as it may lead to financial/operating difficulties (constant strikes, disruption
of production, lower employee productivity, etc.), which will ultimately end up in closure of business.
12. International Developments:
In this ever-shrinking world, events in other countries can sometimes have far reaching consequences in
businesses operating in another part of the world as well.
The above list, while it covers most of the important sources of operating risks from the external
environment, it is not all inclusive, given its dynamic nature. Different geographical locations can throw up
varied external risks such as floods, etc. Inherent strengths and wise business strategies can nullify or
reduce the impact of external risks. Another aspect to be borne in mind is that of the most of the external
variables discussed above are sources not only of operating risks but also of opportunities. They are also
often interlinked. Business cycles, national income, monetary and fiscal policies are close cousins. Changes
in one can trouble others as well.