Balance between business and financial risks
Companies in volatile environment should keep debt to minimum
By Shigeru Nishiyama
The game industry has recently emerged as one of the most profitable in Japan with the major companies being DeNA established in March 1999 and GREE in December 2004 whose excellent performances are supported mainly by their mobile games.
The two started in different industries, and after several years, they entered the game sector to achieve outstanding growth. When we observe them carefully, we can find that they kept a good combination of taking high business risks and securing a strong financial position with no net debt.
In terms of the balance between business risks and financial risks, companies can be divided into either a well-balanced group or a poorly-balanced one having some problems. In this article, the relation between the two types of risks will be discussed.
First and foremost, the meaning of risk should be clarified. It is usually defined as volatility _ in other words, the level of fluctuation. Among various kinds of risks, a business risk is defined as volatility related to the fluctuation in sales and operating profit. It is connected with the intensity of the change in the market, the level of competition, the level of competitive advantage and the weight of fixed cost, which may become a hindrance against making profits.
In general, corporations, which face fast-changing markets, are under severe competition, and have fewer competitive advantages and higher fixed costs, should have a greater fluctuation in terms of sales and operating profits. Then their business risks should be regarded as higher and vice versa.
On the other hand, financial risk, in this article, means the level of the possibility of facing financial difficulty, such as bankruptcy, which is related to the size of a debt or debt-to-equity ratio. The larger these obligations become, the higher the financial risk turns to be.
Based on the combination of these two types of risks at different levels, companies can be separated into a total of four groups.
(1) High business risks and low financial risks（well-balanced group A）
DeNA and GREE belong to this group. They are running relatively high business risks but their financial risks are very low because they have no net debt and a large amount of cash reserves amounting to around $750 million, which is almost 40 percent of their sales.
(2) Low business risk and high financial risk （well-balanced group B）
An example of this group is a railroad company. Its sales and operating profit are usually stable, and they face relatively little competition and some regulation from the government.
On the other hand, it usually has a larger amount of debt to operate the capital intensive business of railways, trains and stations. Such high financial risks are offset by the lower business risks, so it is in a well-balanced situation.
(3) Low business risks and low financial risks (conservative group)
Companies in the food industry with no debt belong to this group. The food market is usually stable and competition isn’t so severe as companies with established brands enjoy relatively strong competitive advantages. Stable turnover and operating profits reduce business risks.
As for the financial side, we can find a lot of no-debt companies in Japan’s food industry. Those firms should be in the conservative group with low risks on both sides.
In this case, they can use their surplus power and take risks by acquiring other firms or making big investments.
(4) High business risks and high financial risks (dangerous group)
Information technology companies whose businesses fluctuate widely with a large amount of debt are in this category. Such players would fall into crisis easily when performance deteriorates. The firms should lower financial risks by cutting down debt as soon as possible or lower business risks by restructuring or downsizing.
Which group do Samsung Electronics and Apple belong to? Their business risks can be evaluated as relatively high because of the volatile environment of their sector, including semiconductors, liquid crystal display panels, televisions and smartphones.
On the financial side, however, both Samsung and Apple have no debt with a war chest of billions of dollars. Hence, their financial risks are quite low and both outfits seem to be in the well-balanced group A.
However, several Japanese companies, which compete against them, take relatively high business risks with a relatively large amount of debt. The situation seems to be close to that of the ``dangerous group.’’
Of course, one of the major reasons why those Japanese entities lag behind is their weak competitive advantage. The weak balance between the two risks would be another primary reason.
It is important for the stable and sustainable growth of the companies to keep a good balance between business risks and financial risks.
This topic is related to attaining an optimal financial structure, a famous theory in corporate finance. The theory explains that there is an ideal balance in debt to equity ratio ― companies can balance the advantage of reduced tax payments from interest expenses for debts and the disadvantages from taking financial risks by borrowing.
The balance between financial risk and business risk in this article, which shows a slightly different aspect of an optimal financial structure, should also be considered by companies.