Risk Assessment. The business of Tesco - Essay Example

Risk assessment assignment Introduction Tesco and its activities Tesco is a multinational enterprise that runs its business in general merchandizing and grocery with the help of retail chain of stores spread all over the world. The company is the second largest retailer in the world in terms of net earnings and the third largest in terms of revenue earnings among all the retail merchandisers (Kerzner 27). Tesco has its retail stores spread over 14 countries all over the world and also holds the leading market share in the retail markets of UK. The primary products of Tesco include the retail grocery items and other retails consumer products that are being sold through its departmental stores, supermarkets and the retail chains. The economic liberalization policies adopted by the policy makers have resulted in the increase in the number of players in the retail grocery markets of UK and in other countries. In order to attain sustainability of business, Tesco has diversified its product portfolio with the activities of retailing of clothes, electronic items, music DVDs, books , financial services, etc (Tesco 1). Vulnerability to risks The business of Tesco which is spread in several countries all over the world is vulnerable to several risks. A list of risks to which the business of Tesco is vulnerable has been given in tabular form below. Sl. No. Risk 1 Interest Rate Risk 2 Foreign Currency Risk 3 Liquidity risk 4 Credit Risk 5 Insurance Risk The two major risks to which the business of Tesco is most vulnerable are the interest rate risk and the foreign currency risk (Frank 174). Due to the increase in interest rates as an outcome of the monetary policy, the interest payout in the form of debt liabilities are likely to increase (Weston 24). This would result in increased cash outflows which reduce the net income of the group and also lesser repayment of debt and liabilities. This is risky for Tesco as they would continue to have higher proportions of debt with respect to the equity (Tesco 1). The foreign currency risk is the uncertainty that Tesco faces due to the fluctuation of currencies in the local markets. As a result of the depreciation of the local currency, the currency conversion rates between the local currency and Pound Sterling would be affected (Cowan 96). This poses the risk to Tesco as foreign currency fluctuation would result in reduction of revenue earnings of the group and the volume of profits repatriated to the home country would also decrease (Whaley 226). Probability The probability of the two risks, namely the interest rate risk and the foreign currency risk have been explained as follows based on the information available from the annual reports of Tesco and the events that have occurred in the last financial year. The interest rate risk poses uncertainty to Tesco as the company is subject to fluctuation of interest rates by the central banks in several countries (Sullivan and Sheffrin 172). As per the information available from the annual reports of Tesco, it has been observed that the company had to bear the cost of increase in the interest rates implemented by the central banks. As monetary policies and in order to control the inflation rates in the economy, the increase in the interest rates has been implemented by the central banks in many countries where Tesco runs its operations (Brown 341). Thus the cost of debt incurred by the company has increased (Handlechner 36). The probability for the fluctuation of interest rates has been assumed to be 60% looking at the trend of impacts on the financial parameters of Tesco’s performance. It is highly probable that the foreign currency conversion rates are further going to fluctuate as the economies are in the mode of restructuring after the occurrence of the global financial crisis (Hennessy and Zechner 271). The uncertainty in the foreign currency conversion is likely to have a cascading effect on financial performance of Tesco. The cost of finance obtained by Tesco in the local markets is likely to increase due to which the outflow of cash is expected to increase that would result in the decline of profits (Khatta 46). The world economy has also been subject to fluctuation with operating profits of the company witnessing a decline all across UK, Asia, Europe, etc. From the records on fluctuation of local currency as available from the industry news, the probability of foreign currency risk has been fixed at 40%. These are two major risks that have high probability to impact the performance of Tesco (Droms and Wright 135). The probability of interest rate risk and the foreign currency risk have been used in the EMV model. The probability of the risks has been multiplied to the expected monetary value of each if the risk to find the individual expected monetary value (Fernie 27). The probability of various financial risks of Tesco has been considered in the risk management process to identify the major risks. The probability of each of these risks have been used to rate these risks (Hillson 75). Potential impact The potential impact of each of the two risks, namely the interest rate risk and the foreign currency risk on the performance of Tesco have been determined based on the evidences obtained from the annual reports of the company and the industry trends (Henry 53). Due to the fluctuation of the interest rates, the retail industry has been widely affected in terms of increase in the burden of cost. The multinational companies that have world wide presence are likely to be affected by the fluctuation of the interest rates initiated by the central banks (Solberg 91). The competitors of Tesco like Wal-Mart and Carrefour have also incurred the additional interest payments as a result of the changes in the interest rates in several countries like UK, US, China, India, etc. On the same lines, the finance cost of Tesco has also increased from $411 million to $450 million in the last fiscal due to the increase in the interest payments on the debts incurred by the company (Wenderoth 248). As per the financial information published by the management in the annual reports of Tesco, the net cash outflow of the group has also increased from $1366 million in 2012 to $ 2365 million in 2013 due to factors like fluctuation of interest rates and foreign currency. This has resulted in the delay of repayment of debt obligations and the long term financial debt has increased from $9911 million in 2012 to $10068 million in 2013 (Tesco 1). Thus the potential impact of the fluctuation of the interest rates and foreign currency is significant for Tesco. Based on this information and the probability of fluctuation of the interest rates and foreign currency risk, the potential impact of the interest rate risk could lead to an increase of increase of the long term debts of the company by 10% (Conrow 82). The potential impact due to the foreign currency risk on Tesco is also considerable which could be understood from the industry wide trends where the multinational retail chains have witnessed decline in the profits earned by them. Due to the fluctuation of the foreign currency exchange, the net profits that Tesco have been able to repatriate to their home economy have declined (Chance and Brooks 63). The decline of net profits of Tesco from $2814 million in 2012 to $120 million in 2013 is evidence to this fact which could be observed from the financial statements of the company. The potential impact due to the fluctuation of foreign currency conversion rates is expected to result in further decline of net profit by 15% as compared to 2013 (Gardiner 172). Overall rating The table given below shows the expected monetary value of the interest rate risk and the foreign currency risk. Sl. No. Risk Probability Monetary Impact (?m) Expected Monetary Value (EMV) (?m) 1 Interest Rate Risk 0.4 -101 -40.4 2 Foreign Currency Risk 0.6 -20 -12 Total EMV (?m) -52.4 The rating of the interest rate risk and the foreign currency risk using the simple grid model have been shown in the table given below (Jolly 75). The interest risk has been rates as 3.8 which is higher than the foreign currency risk which has been rated as 2.1. Parameters Interest payment Net Cash Outflow Long term debt Net Profits Total Weights 0.25 0.2 0.25 0.3 1 Interest Rate Risk 5 3 3 4 15 Interest Rate Risk (weighted) 1.25 0.6 0.75 1.2 3.8 Foreign Currency Risk 1 2 1 4 8 Foreign Currency Risk (weighted) 0.25 0.4 0.25 1.2 2.1 Based on the EMV model and the simple grid model of risk management, the two risks have been prioritized as given in the table shown as follows. Priority Risk EMV (?m) Simple Grid Value 1 Interest Rate Risk -40.4 3.8 2 Foreign Currency Risk -12 2.1 Potential solutions and strategies to address the risk The business of Tesco require establishment of retail stores, a strong supply chain for distribution of its products, warehouse and transportation cost, administrative costs, the business requires short term and log term sources of funds to be raised from the local markets. The fluctuation of the corporate lending rates of the local financial framework would pose considerable risk to the business in short term as well as long term business requirement. The lending rates are influenced by the fluctuation of the interest rate as implemented by the central banks in the markets where Tesco operates. Thus Tesco should adopt strategies for mitigation of risk posed by the fluctuation of interest rates. This is due to the fact that the variation of interest rate is likely to increase the repayment instalments of the acquired debt due to the increase in the payout of interests. The strategies that could be adopted by Tesco in order to mitigate the interest rate risk and the foreign currency risk could be determined with the industry analysis and the similar strategies adopted by the companies in order to mitigate the same risks that posed uncertainty to their business. Tesco should implement strategies of risk management after assessing that the cost of implementation of the strategies does not exceed the cost of risks. The objective of Tesco would be to reduce the impacts on the profitability of the company due to the rise in the interest rates in different economies all over the world where Tesco runs its business. The company could look to explore the options of the derivative market (Madhumathi 56). The forward rate agreement could be entered by Tesco in order to hedge the risk of short term interest rate and foreign currency fluctuations. The company could also enter into interest swaps to exchange the risk of investments at a certain cost. Tesco could look to attain appropriate mix of fixed interest rate and floating rate of interest in order to mitigate the fluctuation of interest rates (Mayo 11). The strategies need to be adopted by Tesco for mitigation of the foreign currency risk. This is due to the fact the any depreciation of the local currencies would change the currency exchange rates. Thus Tesco would be in a loosing position in case of repatriation of profits to their home economy. In anticipation of the foreign currency risk, Tesco should look to undertake the following strategies for mitigation of foreign currency risk. The fluctuation of anticipated foreign currency changes in the short term as well as long term could be mitigated by the use of forward purchase and sale of foreign currencies. The currency options also provide alternate ways for the company to reduce the effects of foreign currency fluctuations (Chapman and Ward 262). The movements of the foreign currency need to be tracked on a daily basis and a trend analysis of the foreign currency exchanges rates between the local economy and the home country need to be conducted. This would provide the management on the procedure to be adopted and time for the use of forward purchase and sale of foreign currency. Looking at the fluctuation of the currency exchange rates, Tesco could also look to hedge part of the investments in selected local economies with a view to reduce the over effects of foreign currency risk on the performance of the group (Tarantino 43). All these strategies are recommended to be used by Tesco in order to mitigate the impacts of both the interest rate risk and the foreign currency risk. Work Cited Brown, Lyndon. Marketing and Distribution Research. 2009. New York: Ronald Press Company. Print. Chance, Don. and Robert, Brooks. Introduction to Derivatives and Risk Management. Stamford: Cengage Learning, 2009. Print. Chapman, Chris. and Stephen, Ward. How to Manage Project Opportunity and Risk. 2011. Chichester: John Wiley & Sons Ltd. Print. Conrow, Edmund. Effective Risk Management: Some Keys to Success. New York: AIAA, 2003. Print. 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