Risk Management in Brewin Dolphin Holdings Plc - Essay Example

Risk Management in Brewin Dolphin Holdings plc Task Table of Contents Table of Contents 2 Introduction 3 Business and Key Market Study 3 Financial trends 4 Profitability 5 Net profit margin 5 Liquidity ratio 6 Current ratio 6 Investment Ratio 6 Dividend per share 6 Efficiency ratio 7 Total asset turnover 7 Corporate and financial actions 8 Risk Management 9 Foreign Exchange Risk 9 Political Risk 13 Conclusion and Recommendations 14 List of References 15 Introduction Brewin Dolphin Holding PLC (BDH), based in the United Kingdom, is a company that offers investment services to its client. The industry in which the company operates is the financial services. Brewin Dolphin Holding offers private investment advice to its richly diverse customers. The company operates in the following markets: England, Wales and the Channel Islands, Northern Ireland, Scotland, Bell Lawrie, Wise Speke in the North of England, and Hill Osborne in the East Midlands. This shows the extent of local market coverage by the Brewin Dolphin plc. BDH operates several subsidiaries which are wholly owned. The subsidiaries include Brewin Nominees Limited, North Castle Street (Nominee) Limited, and Brewin Dolphin Limited (that manages investments). In the recent past, the company formulated and implemented a new strategy that boosted the transformation rate of the services offered and increased the overall growth rate (BDH: Annual report 2013, pp. 1-9). This essay presents an in-depth analysis on the company, its market activities, and the company’s approach to manage various risks such as the exchange rate risks and political risks (BDH: Annual report 2013, pp. 3-9). Business and Key Market Study The company operations are divided into two segments such as the investment management and corporate advisory and broking. Under the investment management segment, the following are the investment management advisory services provided by the company: pensions (including self-invested Pension plans), inheritance tax relief, ISAs and other tax-efficient investments, and international investment portfolios. Under the Corporate advisory and broking segment, the following activities are undertaken: market research, trading and sales services, and activities involving merger and acquisitions, debt advisory services among others. There is an increase in the demand for personal financial management advisory services. Thus, there is an anticipation of future growth in the market (BDH: Annual report 2013, pp. 6-14). The driving force behind the increase in demand is the increasing rate at which the society strives to become financially independent. In the United Kingdom alone, two million individuals were estimated to own liquid assets in excess of £ 100,000 by the end of the year 2012. By that time, only £ 548 billion of the funds were under the management of wealth management companies in the UK. Out of the eleven wealth management companies, Brewin Dolphin managed 15% of the total funds, giving a market share of 15%. Competition in the industry is constantly growing thus, BDH has become relentless in the formulation and implementation of strategies that facilitate the delivery of superior quality services to their clients (BDH: Annual report 2013, pp. 6-14). Financial trends In this section, the financial trends of BDHP will be analysed in terms Profitability, Efficiency, Liquidity, and Investment return. Year 2013 2012 2011 2010 2009 PROFITABILITY RATIO Net profit margin 7.82% 7.27% 5.68% 9.62% 8.3% LIQUIDITY RATIO Current ratio 1.3 1.16 1.16 1.13 1.06 EFFICIENCY RATIO Total asset turnover 0.4940 0.5672 0.5289 0.4148 0.3987 INVESTMENT RATIO Dividend per share 0.086 0.071 0.071 0.071 0.071 Profitability Net profit margin Net profit margin shows the portion of the company’s sales that are net profit (Heerkens 2006, pp. 24-29). From the graphical presentation above, one can understand that there has been a sharp increase in company’s net profit in the year 2010 to 9.62% and thereafter, a sharp decrease to 5.68% in 2011. However, the net profit rose steadily from year 2011 to 2013. The witnessed trend was due to an increase and a decrease in the net profit in year 2010 and 2011 respectively (Fridson & Alvarez 2011). The steady increase in the ratio for the year 2011 is due to an increase in the net profit. For the whole period, the company’s operating and administrative costs were higher because more than 90% of the sales were consumed such expenses. The issue can be fixed when the company formulates and implements more effective costs management strategies (Gildersleeve 1999, pp. 9). Liquidity ratio Current ratio Current ratio measures the ability of a company to sufficiently meet the current obligation using the current assets (Robinson, Munter & Grant 2003). Based on the above graph, the company’s current ratio steadily increases from year 2009 to 2013. In general, for the five-year period, BDH had enough current assets to cover for the current obligations. The steady increase is attributed to the increase in current assets. Therefore, the company should uphold the liquidity position (Wahlen, Bradshaw, Baginski & Stickney 2010). Investment Ratio Dividend per share Dividend per share indicates the cash dividend paid to the stockholders on every share held (Bergevin 2002, pp. 56-57). As is indicated in the graph below, BDH’s dividend per share was constant between the year 2009 and 2012 at 0.071 pounds. However, the ratio increased in the year 2013 to 0.086 pounds. Efficiency ratio Total asset turnover The total asset turnover shows the utilization rate of the total assets of a company toward revenue generation (Neely 2001, pp. 34-36). From the graph above, the total asset utilization rate by BDH steadily increased between the year 2009 to 2012, then declined in the year 2013. The increase is attributed to a more than proportionate increase in sales as compared to total assets. However, the decline in 2013 is attributed to more than proportionate increase in the company’s total assets as compared to the sales level. For instance, in year 2013, every pound invested as total assets was utilized to generate £ 0.494. The same interpretation, but different figures applies to other cases (Zaire 1994, pp. 32-34). Corporate and financial actions BDH is one of the largest personalised investment service providers in the UK. As mentioned above, the company’s primary goal is to create shareholder value through increasing revenue growth and to deliver superior quality services to its clients effectively. In addition, it has a vision of becoming the top provider of individual discretionary wealth management in the United Kingdom. Corporate and financial actions are activities that have a significant influence on the shareholders. In the year 2012, BDH experienced a major change in the composition of its board members, which gave the board a new “face”. The board restructure has had a significant influence on the company’s efforts toward the achievement of its major goals (BHD annual report 2013, pp. 5-6). In addition, for the whole five year period, the company has been paying a constant dividend of 1 pence to its shareholders. Based on the above financial analysis, the following are the areas of strength for BDH: first, the current ratios show a strong liquidity position of the company. The reason is, for the five year period, the current ratio was above 1, indicating the company’s ability to sufficiently meet its current obligation (Taticchi 2010, pp. 45-47). Second, BDH was able to pay cash dividend. The payment of cash dividend is an indicator of both current and future strong financial position. On the other hand, the following are the company’s areas of weakness: First, the net profit margin indicates ineffectiveness in the company’s cost management strategies since the company’s operating costs use up more than 90% of the revenue generated. Second, the total asset turnover shows a weak utilization rate of the company’s total assets. The company should improve the asset utility rate in order to increase revenue generation (Taticchi 2010, pp. 57-60). Risk Management BDH has following business risks from its usage of financial instruments. Some of these risks include market risk, liquidity risk, credit risk and operational risk, which are not easy for the group to control (BDH Annual Report 2013, pp. 103). These risks offer challenges to the organization and its future if it is not well administered. As a result, the group has established the means to overcome and administer these risks. BDH’s risk management policies are aimed to make sure that risks are recognised, assessed and subject to continuing overseeing and reduction where it is possible. The risk policies are aimed to establish the necessary controls, the effectiveness and adequacy of which are also subject to review and testing periodically (Duckert 2010, pp. 1) Foreign Exchange Risk The management of foreign-currency risk has become more significant for investment management companies to safeguard them from the loss due to changes in foreign currency. (Papadopoulos 2011, pp.1). A volatile exchange rate presents an environment that is too risky for businesses to operate (Thomas, Finkle & Wilkinson 2010). Exchange rate risks are categorized into transaction, economic and translation risks (Elson, OCallaghan, Walker & Tang 2013). A transactional exposure arises from the various trading activities that a company engages in. Globalization has made the world a small village where companies in the various parts of the world are well connected. The process of globalization has facilitated the sharing of resources between different companies too. Businesses that operate in the international markets face greater risk of future price movements. The reason is, they borrow, lend, invest and receive cash inflows denominated in foreign currencies (Dow & Kunz 2009). It is from the trading activities of a business that transactional risks arise. Secondly, economic risk is the adverse changes in a company’s present value of future cash inflows and out flows due to unfavourable movements in the exchange rate and inflation differential between countries. Companies that have invested in several foreign countries face low negative economic impact due to offsetting. That is, losses made due to unfavourable exchange rate movements are offset by profits made due to favourable exchange rate movements. Lastly, the translation risk arises from consolidation of financial statements of subsidiary companies (Dow & Kunz, 2013). During the consolidation, conversion of some figures into the local currency is mandatory. If the local currency were weaker than the foreign, the financial figures would be shrunk. Even though these exposures pose a huge threat to many businesses, there exist methods of reducing the effect (Matsukawa & Habeck 2007). The methods have been classified into two categories such as the financial contracts and the operational techniques. The financial methods of hedging the exchange rate risk are forward market hedge, money market hedge, the option market hedge, and the swap market hedge (ow & Kunz 2008). On the other hand, the operational techniques used to hedge the same risk are the choice of invoicing currency, leads and lags and exposure netting. The financial contracts mentioned above are among the most effective exchange rate risk mitigating strategies. The adoption of hedging strategies protects corporations from unforeseen losses attributed to future negative changes in the exchange rates. Hedging in the context of exchange rate refers to evading the negative impacts of exchange rate fluctuations (Marrison 2002, pp. 45-48). First, forward market hedge involves the agreement to buy or sell cash inflow or out flow in the future at a pre-determined exchange rate. In other words, the parties to such a contract agree, at the time of contract, on the exchange rate to be adopted in the future when the contract matures. The determination of the future exchange rate is done using various forecasting methods based on the historical rate movements. Therefore, the hedging strategy reduces potential losses due to unfavourable exchange rate movements as follows: the pre-determined rate could be higher than the spot rate experienced when the contract matures. In this case, the exchange rate to be adopted would be higher (the pre-determined rate). That way, the company will have avoided the losses arising from the adoption of the spot exchange rate (Marrison 2002, pp. 45-60). The following are advantages of the forward market hedge: first, the period of the contract can be adjusted to correspond to the exposure period. Second, forward contracts are traded over the counter. Therefore, they can be customized to fit the terms of any particular transaction. Third, the contract is easily understood and offers protection against price changes. On the other hand, the following are the disadvantages of the forward market hedge: first, since it is not standardized, the contract is subject to a high rate of default risk. Second, the counter parties are not easy to find. Third, it might be difficult to terminate the contract (Matsukawa & Habeck 2007). Second, the money market hedge involves evading the negative impacts of foreign exchange fluctuation by borrowing (investing) in the foreign country to hedge a receivable (payable) (Matsukawa & Habeck 2007). That is, when BDH expects a receivable denominated in say Swiss Franc, a similar amount of the receipt is borrowed from Switzerland and invested in the UK. The loan will then be repaid by the receivable since the maturity period is matched with the contract maturity. Therefore, in this contract, the receivable will be used to pay a Swiss lender (will not cross boarders to the UK). Thus, in case the Swiss currency moved unfavourably, the UK party will have evaded losses attributed to the movement. The following are the advantages of the contract: first, it is safe due to the involvement of government securities. Second, high interest rates are experienced on the money market compared to savings account. Third, the money liquidity of the money market is high. On the other hand, the following are the disadvantages: first, it is difficult to understand due to its complexity. Second, it is volatile since it derives its value from the value of an underlying asset (Kritzman 1993, pp. 1-7). Third, the option market hedge confers the right but not the obligation to buy or sell currency at a pre-estimated rate in the future. That is, one of the parties to contract has the power to choose whether to sell or buy currency at the estimated future rate, when the contract matures (Froot & Thaler 1990). That way, an inherent loss can be evaded when the parties to contract declines to exercise the contractual right when the future spot rate is favourable. The following are some of the advantages of the contract: first, depending on the use, the contract is less risky. Second, they are flexible since they provide more choices to investments. On the other hand, the following are the disadvantages of the contract: first, it involves high costs due to commission fees. Second, options are difficult to manage since they require constant observation of the strike prices (Froot & Thaler 1990). Last, the exchange rate swap is a contract that involves buying and selling of two different currencies simultaneously, but for use in two different periods (Papaioannou 1989, pp. 23-24). That is, during spot and forward transaction. The transaction reduces the risk by offsetting the negative exchange rate movement during the simultaneous buying and selling of the two currencies (Jorion & Wystup 2002). It results in risk minimization for both parties. The main advantage of the contract is that it allows the parties to exploit market opportunities more efficiently by consolidating their currency advantages. On the other hand, the primary disadvantage of the contract is the failure of either party to respond to the contractual terms (Jorion & Wystup 2002). The first operational technique used to manage the exchange rate risk is choice of invoicing currency. BDH could decide to invoice its receipts using pounds rather than the foreign currency. This way, BDH shifts the exchange rate risk to the foreign party when the value of pound increases against that of the foreign currency. Alternatively, BDH could decide to invoice a portion of the receipt in pounds and the remaining in foreign currency (Thomas, Finkle & Wilkinson 2010). Second, lead and lag method can be adopted. This strategy involves delaying receipts or payments and leading payment and receipts depending on the anticipated rate of foreign exchange. Leads refer to making either quick payments or demanding quick payments whereas lags refer to delaying both payments and receipt. Last, the exposure netting is a method that hedges risk when losses made are covered by gains as a result of the exchange rate fluctuations. Therefore, companies are encouraged to hedge their portfolio of currency receipts and payables (Thomas, Finkle & Wilkinson 2010). According to the BDH annual report (2013, pp. 80), the figures in the financial information on the BDH group are expressed in terms of the functional currency (sterling pound). During the preparation and consolidation of the financial statements, BDH group’s foreign subsidiary financial statements were converted to sterling pound using the prevailing exchange rate at the time of conversion (Brent, W. & Mahone, Charlie 2007). However, when the exchange rate fluctuates significantly, the exchange rate at the time of transaction is adopted to avoid either significant gains or losses to the company (BDH annual report 2013, pp. 80). Political Risk Political risks are uncertainties that arise as a result of changes or implementation of rules and regulations, by the politicians of a host country, that have negative impact on the performance of the company. The most common political risks are caused by the following factors: inconvertibility of currency, asset expropriation, breach of contracts and war and civil unrest. All the named risks cause financial losses and reduces the level of return on investment to the organization. Both currency inconvertibility and asset expropriation are directly caused by the government thus could be mitigated by entering into a private agreement with the government that woul allow easy currency conversion and prevent asset confiscation. Contract breach is commonly mitigated through arbitration and legal suit. Last, damages caused by war and civil unrest are managed through the purchase of insurance policies (Lam 2003, pp. 45-50). Concerning BDH, risk arises due to the ineffectiveness of the internal processes of the organization, systems and people or from negative externalities (Matz 2011). Under this category, the risks involved are the regulatory and legal risk, which connotes the risk due failure in adherence to laws and failure to observe contractual commitments and ethical standards (Ruozi & Ferrari 2013). The company mitigates the risks by ensuring the following: that the laws and regulations are observed, that the contractual obligations are met and that the underlying ethical standards in the industry are strictly followed (Koran 1982). Conclusion and Recommendations The essay contains analysis of BDH Company and its business activities, the market analysis and the competitor analysis. In addition, the following analyses have been included: financial ratio analysis, analysis of exchange rate risk and political and their mitigation strategy. The financial ratios included are the current ratio, the net profit margin ratio, dividend per share and the total asset turnover. Concerning political risk, the company should implement all the above methods discussed. At the same time, the current political risk management method should be maintained in order to increase the effectiveness of BDH’s risk management. In addition, concerning the exchange rate risk, BDH should consider the money market hedge since it both minimizes risk and offers opportunities for the company to make high return investments thus, improve cash flow generation (Mckellar 2010). Finally, the company should formulate and implement more effective strategies to manage operating costs and increase the profitability level. 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