Differences in the Risk of a Clothing Company and a Utility Company
A clothing company has high exposure to both diversifiable and non-diversifiable. Diversifiable risk exists within the company because of internal activities of the entity (Hopkin, 2013, p. 2). The company can avoid this type of risk by diversifying its investment portfolio. The clothing company has much exposure to this risk because they concentrate on one investment, clothing. On the other hand, the clothing company cannot avoid non-diversifiable risk because non-diversifiable risk affects the whole market (Jordao & Sousa, 2010, p. 2).
On the other hand, a utility company has limited exposure to diversifiable risk. The company has an investment in various sectors, unlike the clothing. However, it is also prone to non-diversifiable risk because it has no control over this risk.
The clothing company has the potential of higher risk because of exposure to both diversifiable and non-diversifiable risk that results from market conditions.
Sources of Risk
- Competitors- competitors pose a potential risk for the companies because they share the market domain with the respective companies.
- Creditors- at times, creditors often state difficult terms for the loans granted to the companies. They pose a risk in terms of the independence of the management to make decisions.
- Statutory requirement- the government may pass a law that undermines or terminates the activities of the business (Krause, 2006, p. 2).
Stability and Variability of Earnings
The clothing company will have unstable earnings because it concentrates on one line of business or investment. Therefore, its income fluctuates according to the change in demand for its clothing products. For instance, it could generate an annual revenue of 500000 dollars when the demand is high and fall to 300000 when the demand declines.
The utility company has relatively stable earnings because its investment portfolio is diverse. When one sector fails, the boom in another sector can help the company to remain at the same level of earnings.
The optimal debt ratio for most companies should be more than 0.5 (Guerard & Schwartz, 2007, p.3). The clothing company has a lower debt ratio because it has one line of investment. It will borrow lesser funds because it does not need to diversify the available equity. On the other hand, the utility company will have a higher debt ratio (less than 0.5) because it borrows more funds to invest in its diversified investments.
Guerard, J., & Schwartz, E. (2007). Quantitative corporate finance. (Springer e-books.) New York, NY: Springer.
Hopkin, P. (2013). Risk Management. London: Kogan Page.
Jordão, B., & Sousa, E. (2010). Risk management. New York: Nova Science Publishers.
Krause, A. (2006). Risk management. Bradford, England: Emerald Group Pub.