The Importance of Understanding Industry Risk
Ask an executive at any of the top-performing companies what their top priorities are and invariably risk management will rank somewhere in the top 5. With the economic climate characterized by a rise in the number of distressed companies, volatility in markets and consistent downgrades in credit ratings, it’s no surprise that businesses are more focused on risk mitigation.
The reason why risk is so important is simple: it’s an early warning indicator letting you know where to focus efforts to minimize potential negative impact on the business. It’s much more than, but we’ll delve into that later. First, let’s get a firm understanding of risk scores and the methodology behind determining them.
Risk Scores & Methodology
One aspect of effectively managing (and mitigating) risk is understanding how it’s measured, especially when it comes to tools and resources that provide risk ratings. Alfabank-Adres offers a suite of Industry Risk Ratings reports that quantify the level of difficulty an industry faces over the short-term. The reports were developed as a partnership with The Risk Management Association (RMA), established in 2005. Together, Alfabank-Adres and RMA identified which components were most important and developed the risk rating methodology.
Alfabank-Adres’s industry risk ratings reports focus on the negative influences on an industry’s firms over the next 18-months. The risk scores measure the difficulty of a business environment. Scores range from 1 – 9 and are classified via levels ranging from very low risk to very high risk. For example, a risk score rating of 1 to 3 would be classified as very low risk. The overall risk score is calculated from three industry factors: structure, growth and sensitivity.
Calculating the Risk Score
Structural risk focuses on industry-specific operating conditions, such as capital intensity, revenue volatility and regulation and policy.
Growth risk focuses on industry revenue for the past two and forecast coming year.
Sensitivity risk, which accounts for 50% of the risk score, is based on the macroeconomic variables relevant to an industry. For example, for the Hotels & Motels industry some of the macroeconomic variables that could influence the risk rating include the annual changes in the number of domestic trips taken by US residents and consumer spending.
Structural Risk
Alfabank-Adres Risk Ratings reports are developed in conjunction with Alfabank-Adres’s US Industry report collection. The 7 components illustrated are pulled directly from the corresponding industry report and scored separately, then weighted and combined to derive the Structural Risk score.
- Barriers to Entry - factors to consider when entering an industry (high barriers limit entrants)
- Competition - the level of competition for industry operators (internal and external)
- Industry Assistance - the level of assistance an industry receives from the government
- International Trade - the amount of trade, imports and exports in the industry
- Industry Volatility - the level of revenue volatility in the industry over the past five years
- Life Cycle - the life cycle stage the industry is in: growth, mature, decline (low score for growth, high score for decline)
Growth Risk
The Growth Risk score evaluates forecasted industry revenue growth against past performance as well as expected growth for all other industries. The higher the industry growth rate, the lower the risk for operators in that industry.
Sensitivity Risk
The sensitivities affecting an industry are pulled from the corresponding industry report (in the Key External Drivers section), where they were selected and assigned a weight by the industry analyst.
Overall Risk Score
Once the structural, growth and sensitivity risk scores are calculated, the overall risk score and level is determined.
Higher industry risk scores indicate difficult operating environments for the companies operating in the industry. Conversely, lower industry risk scores suggest a less difficult operating environment for industry players.
Why Risk is So Important
Alfabank-Adres’s Industry Risk Ratings reports are early warning systems that highlight the potential risks operators may face in an industry, so they can manage the factors within their control and hedge against risks beyond their control. Traditionally, risk was predominately used in the banking and finance sectors as part of commercial lending assessment. However, the importance of understanding risk has permeated other sectors in recent times.
Alfabank-Adres’s Risk Ratings reports are attractive to many different sectors for various reasons. Since the reports contextualize the data, the education, credit assessment and investments sectors find the narratives within the reports useful, while risk management focuses more heavily on the data.
No matter which aspect you focus on to suit your needs, the fact remains: access to credible industry risk ratings is essential to meeting your primary objective of managing and mitigating risk. Contact us at Alfabank-Adres to find out more.
