Risk Definition Business

Risk Definition Business

Businesses are often very large and complex organizations. However, by tracing the development of a company from one person's idea into a major corporation. We can get insights into that complexity like risk treatment options iso 3100 and risk definition business. Consider the following fictionalized account of Henry Ford's automobile manufacturing company. Note how each decision in the the company's evolution can affect the value and decisions of the company. Each step adds another interested party, called a stakeholder. A stakeholder is a constituent who has a legitimate claim of any sort on the company.

Start Up

Henry started with the idea of making a car affordable for a large number of people. Using his own money, he bought raw materials, built one car by himself and sold it to a satisfied customer, earning a profit. He reinvested the money from the sale, bought more raw materials and made more cars.

Henry provided the entire financing himself. Henry is also the manager of the company . In fact, at this point, besides suppliers and customers, Henry is the only person directly involved in the company.

Henry's primary motivation was to earn money. But what happens if the company is unsuccessful? That is , what happens if Henry can't sell his cars for a profit? Eventually, Henry would run out of money. Under some circumstances, then Henry can lose the money he invested but no one else strands to lose anything.

At this initial point, we want to note three things First, Henry has exclusive ownership of the company and its assets. Second, Henry has complete control of the company and its assets (within legal limits). Third, Henry is bearing all the risk associated with the company's investment.

Debt

Building one car at a time was OK, but it occurred to Henry that if he could buy more raw materials with each order, he could save money on shipping charges. Henry (and, therefore, the company) did not have enough money to make such large orders. So Henry went to a bank and borrowed some money. Her Promised to repay the money out of revenues from future car sales. 

Note that the company's financing its capital structure is now made up of two parts. (We use TA to represent the liabilities plus stockholders equity to emphasize that the accounting identity must always hold.) The two parts of the company's new financing are debt and equity. Equity represents ownership, whereas debt is a legal obligation for borrowed money. As the only Shareholder or Stockholder or equity holder, Henry still has exclusive ownership of the company and its assets. Henry also retains direct control over the company and its assets because he is the manager of the company. However, Henry is now constrained by bank-loan obligations. His company is required to pay interest on the loan and repay the money it borrowed. The bank has become a stakeholder in Henry's company.

As with Henry, the bank's primary motivation for making this loan was to earn money. Because of this, Henry agreed to pay interest in addition to repaying the loan. But now what happens if the company is unsuccessful? That is , what if Henry can not sell his cars for a profit? Under some circumstances the company might not have enough cash to fully repay the bank. Because of this possibility, the bank is bearing some risk. But how much risk?

On the downside, if it is not fully paid, the bank may still get something, whereas Henry will have lost all of the money he invested. On the upside, if the company does well, the bank will receive only the loan repayment plus promised interest, whereas Henry will git all of the "excess net revenue" everything above the amount promised to the bank. Therefore, Henry does worse than the bank on the downside and better than the bank on the upside. So Henry is bearing more of the risk than the bank. Also the bank must trust Henry to act responsibly and not run off to South America without repaying.

You can see that this situation is more complex than in the start up, where Henry Provided all the financing. Determining the values of the claims on the company is more difficult. The company's decisions are more complex because they affect more stakeholders. Let's review the current situation. First, Henry retains exclusive ownership of the company. Second, Henry still controls the company's assets, but he's constrained by bank loan obligations. Third, the bank now bears some of the risk. Fourth, Henry bears all the residual risk, which is the majority of the company's risk.

Employees

After a while, Henry has an even larger number of orders, so large in fact that it would take him longer than the rest of his life to build those cars and more are coming in every day. To fill the orders, Henry hires some employees. Although the balance sheet does not change, Henry's company now has some implicit obligations to its employees. For example, its employees would be upset if the company delayed wage payments. Likewise, the employees have some implicit obligations to the company. For example, and employee should not use an expense account for personal benefit. Therefore, although neither the balance sheet nor the ownership of the company has changed, Henry's control over the company's assets is further constrained.

Multiple Equity-holders

Demand for Henry's cars continues to grow. Now, although Henry has employees to build the cars on back-order, he is again short of money to buy raw materials. He goes to the bank, but the bank refuses to loan more money. In short, the bank says it won't take the risk of a bigger loan, The bank will agree to loan more money only if Henry puts up more money. But Henry does not have any more money all his money is already invested in his company. So the bank tells Henry to get other equity financing and Henry does. Just like Netscape, he sells Shares in his company to new equity-holders. He also creates a board of directors. 

Where do Henry and his company stand now? First the company is no longer exclusively Henry's. The company has other equity-holders who are part owners. Second, although Henry is still the manager and still has control over the company's assets, he is now even more constrained. In addition to the bank loan and employee obligations. Henry now has an obligation to act in the best interests of the other equity-holders. Third, the bank continues to bear some of the risk of the company. Fourth, Henry no longer bears all of the company's residual risk. He and the new equity-holders now share the residual risk of the company in direct proportion to the number of shares each person owns. 

Separating Ownership from Control

More time has passed and Henry's company is operating more successfully than ever before. But Henry is now tired of his years of working. He's decided he will retire and live off investment returns. So Henry hires special employees, managers, to run the company use the risk treatment options iso 3100.

As with other employees, hiring the managers does not change the balance sheet. Nevertheless, this change is a very important one Henry no longer has direct control over the company and its assets. The managers now control the company's assets, and Henry has become like the other equity-holders. In particular, he must trust the managers to run the company for his benefit, just as the other equity-holders trusted him, hence that is the risk definition business.