| Categories of |
| Financial risk |
|---|
 |
| Credit risk |
| Market risk |
| Liquidity risk |
| Investment risk |
| Business risk |
| Profit risk |
| Non-financial risk |
Profit risk is a risk management tool that focuses on understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective. [1]
Profit risk is a risk measurement methodology most appropriate for the financial services industry, in that it complements other risk management methodologies commonly used in the financial services industry: credit risk management and asset liability management (ALM). [2] Profit risk is the concentration of the structure of a company's income statement where the income statement lacks income diversification and income variability, so that the income statement's high concentration in a limited number of customer accounts, products, markets, delivery channels, and salespeople puts the company at risk levels that project the company's inability to grow earnings with high potential for future earnings losses. [3] Profit risk can exist even when a company is growing in earnings, which can cause earnings growth to decline when levels of concentration become excessive.
When a company's earnings are derived from a limited number of customer accounts, products, markets, delivery channels (e.g., branches/stores/other delivery points), and/or salespeople, these concentrations result in significant net income risk that can be quantified. A loss of just a handful of customer accounts, a loss of a limited number of products, a loss of a select market, a loss of a small number of delivery channels, and/or a loss of a few salespeople can result in significant net income volatility. [4] At this stage, income loss risk is present and the company has reached a level of profit risk that is unhealthy for sustaining net income. The method for quantifying and assessing this potential income loss risk and the volatility that it creates to the company's income statement is profit risk measurement and management. [5] For financial institutions, profit risk management is similar to the diversification strategies [6] commonly used for investment asset allocations, real estate diversification, and other portfolio risk management techniques.
The concept of profit risk is loosely akin to the well known "80/20" rule or the Pareto principle, which states that approximately 20% of a company's customers drive 80% of the business. [7] This rule and principle may be appropriate for some industries, but not for the financial services industry. [8] According to Rich Weissman, [9] it is true that this small group of customers dominate the income statement, but the old "80/20" rule no longer applies. "There are real-life examples where financial institutions have seen profit risk ratios as high as 300 percent. Their top 10 percent of customer/member relationships accounted for three times net earnings – a "300/10" rule!"
To measure these concentrations and manage profit risk, the most important tools for financial institutions may be their MCIF, CRM, or profitability systems that they use to keep track of their customer/member relationship activities. The data in these systems can be analyzed and grouped to gain insights into profitability contribution of each customer/member, product, market, delivery channels, and salespeople. [10] Reports illustrating the concentrations of net income are used by senior management to show (1) the location of the concentrations in the income statement, (2) the levels of the concentrations, and (3) the predictions for future earning losses to be drawn from the concentrations. [11] Often, these reports examine earnings contributions by deciles (groupings of customers or other units of analysis by 10% increments), illustrating concentrations for each 10% group. [12]
Finance is the study and discipline of money, currency and capital assets. It is related to and distinct from Economics which is the study of production, distribution, and consumption of goods and services. The discipline of Financial Economics bridges the two fields. Based on the scope of financial activities in financial systems, the discipline can be divided into personal, corporate, and public finance.
Investment is traditionally defined as the "commitment of resources to achieve later benefits". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broader viewpoint, an investment can be defined as "to tailor the pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows". When expenditures and receipts are defined in terms of money, then the net monetary receipt in a time period is termed cash flow, while money received in a series of several time periods is termed cash flow stream.
The price–earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company's share (stock) price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.
In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive revenue from interest, royalties, or other fees. "Revenue" may refer to income in general, or it may refer to the amount, in a monetary unit, earned during a period of time, as in "Last year, Company X had revenue of $42 million". Profits or net income generally imply total revenue minus total expenses in a given period. In accounting, revenue is a subsection of the Equity section of the balance statement, since it increases equity. It is often referred to as the "top line" due to its position at the very top of the income statement. This is to be contrasted with the "bottom line" which denotes net income.
An income statement or profit and loss account is one of the financial statements of a company and shows the company's revenues and expenses during a particular period.
A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.
In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.
Credit risk is the possibility of losing a lender holds due to a risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.
Mark-to-market or fair value accounting is accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s. Failure to use it is viewed as the cause of the Orange County Bankruptcy, even though its use is considered to be one of the reasons for the Enron scandal and the eventual bankruptcy of the company, as well as the closure of the accounting firm Arthur Andersen.
Financial accounting is a branch of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.
In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.
A statement of changes in equity and similarly the statement of changes in owner's equity for a sole trader, statement of changes in partners' equity for a partnership, statement of changes in shareholders' equity for a company or statement of changes in taxpayers' equity for government financial statements is one of the four basic financial statements.
Passive income is a type of unearned income that is acquired with minimal labor to earn or maintain. It is often combined with another source of income, such as regular employment or a side job. Passive income, as an acquired income, is taxable.
The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are recognized when they are realized or realizable, and are earned, no matter when cash is received. In cash accounting—in contrast—revenues are recognized when cash is received no matter when goods or services are sold.
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
The following outline is provided as an overview of and topical guide to finance:
The CAMELS rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It is applied to every bank and credit union in the U.S. and is also implemented outside the U.S. by various banking supervisory regulators.
A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
Top-line growth is the increase in revenue or gross sales by a company over a defined period and is used to indicate the financial strength of a business and its potential for growth in the future. It is usually measured over periods of one-half or full years and is often reported as a percentage growth compared to the previous year or period. Top-line growth does not accrue across periods, instead it is recalculated based on the performance of the business in a specified reporting period. It is a gross figure that represents economic inflows to the company, prior to the deduction of expenses or changes in equity contributed by the business owners or the investors. Top-line growth is often used as a metric for business growth potential and overall operating performance. In most businesses, it forms an integral part of their strategic planning and a means of assessments for such strategies.