Journal of Economics and International Finance Vol. 3 (15), pp.

780–786, 7 December, 2011

Available online at http://www.academicjournals.org/JEIF
DOI: 10.5897/JEIF11.123
ISSN 2006-9812 ©2011 Academic Journals

Full Length Research Paper

Effective risk management and company’s

performance: Investment in innovations and intellectual
capital using behavioral and practical approach
Mohsen Jafari1, Arezoo Aghaei Chadegani2* and Vahid Biglari3
1
Department of Accounting, Azad University (Science and Research Branch), Tehran, Iran.
2
Department of Accounting, Faculty of Economic and Business, University Kebangsaan Malaysia. Bangi, Malaysia.
3
Department of Accounting, Faculty of Business and Accountancy, University of Malaya, Kuala Lumpur, Malaysia.
Accepted 14 November, 2011

Risk management is used to decrease the undesirable effects of market conditions and behavior on
company’s activities and performance. This research focuses on ability of risk management response
to out of control market factors to facilitate consistent profitability that leads to improvement in
company’s performance. This is an empirical research that investigates the association of total risk
management and company’s performance. The results indicate positive and significant relationship
between total risk management and company’s performance in companies that have invested in
research, development and innovations along with companies that have greater level of intellectual
capital and industries that have rapid knowledge growth. The results confirm the findings of previous
researches in terms of functional and practical behaviors approaches.

Key words: Total risk management, human capital, functional and behavioral approaches, innovation
company’s specific assets.

INTRODUCTION

Some factors that may cause companies to face various importance of the topic, few applied studies has been
unpredictable risks are environmental complexity (Luo, done to determine whether risk management has
1999), intense competition (White and Frame, 2004), practically desirable effects on the firms performance.
advanced technology (Baldwin and Li, 2002), deve- On the other hand due to the conceptual complexities
lopment of information and communication technology, of risk management and variation in methods of
new methods of supplying goods and services, controlling adverse effects of losses, the previous few
environmental issues and companies’ movement from attempts that have been made failed to offer a
tangible to intangible assets. As a result, companies are comprehensive and integrated framework.
faced with several risk management issues including Risk management has several advantages. It inspires
enterprise risk management, business risk management strong stimulus in company’s major stockholders to
and strategic risk management (Woods, 2009). increase their investments in the company. By increasing
Currently, risk management is regarded as one of the their investments such investors invest in company’s
most important concerns of executives and the risk specific assets. These assets are regarded as tools that
management activities are expanding. However, provide better business opportunities toward obtaining
regarding the peripheral effects and applications of risk proper and long lasting competitive advantage.
management, few empirical researches has been done Therefore, it is concluded that lack of effective risk
up until now. In other words despite rapid growth in management may lead to imposition of extra costs on
both investor and investee. By incurring excessive costs
the performance of company is deteriorated. The
previous mentioned issues are some of the indications of
*Corresponding author. E-mail: arezooaghaie2001@yahoo.com the influence of effective risk management on behavioral

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 Jafari et al. 781

functions. namely, environmental uncertainty, industry competition,

In some cases as environmental condition changes, firm complexity, firm size, and board of directors’
some companies continuously earn higher return than monitoring. Finally they argue that for implementing ERM
others. As a result some questions that may arise are: firms should pay attention to the contextual variables that
what could be the reason behind such accomplishments? are surrounding the firm.
Is it effective risk management? How do the functional Andersen (2008) examines the firm-specific investment
and behavioral consequences of risk management affect rationale as a plausible explanation for positive risk
performance? How does risk management affect management effects. As a consequence of the firm-
performance? This study aims to address these specific investment rationale he finds that effective risk
questions. management outcomes are associated with superior
Contribution of this study is twofold. First, this paper corporate performance. Further he indicates that firms
attempts to develop a new concept of risk management. that vary in levels of intellectual capital and investment in
Risk management is defined as a tool that helps in innovation also differ in their risk management effects.
dealing with external market risks that are out of Likewise, Gupta (2011) examines the risk management
management control. Risk management reduces in Indian companies and explore the reasons for the
variation of company’s profit and profit consistency adoption or lack of adoption of integrated approach to risk
reduces the likelihood of financial distress, consequently management. He shows that even though effective risk
reduces cost of capital. management can improve organizational performance,
As a result, company can invest in further feasible companies do not have adequate infrastructure to
projects and proper business opportunities. So, this study implement enterprise wide risk management. He
contributes to the investor’s knowledge through helping concludes that a sea change in risk perception is required
them to make better investment decisions. The remainder to build up risk culture across business segments and
of this paper is organized as follows; literature review; incentivize risk management adoption.
theoretical framework; research hypotheses and
description of the variables; research methodology;
summary of data analysis and findings, and conclusion. Risk management definitions

Risk management is an effective technique for minimizing

LITERATURE REVIEW AND RESEARCH undesirable effects of risks and optimizing the benefits of
HYPOTHESES risky situations (Essinger and Rosen, 1991).
Chapman and Ward (1997) describes the aim of risk
The salient researches that have been done in risk management as process enhancement that is
management context and about consequences of risk established through systematic identification, evaluation
management explained here. and mitigation of project risks. According to these
Francis and Armstrong (2003) investigate the definitions risk management is defined as measures that
connection of ethics to risk management. They argue that are taken to decrease the potential risky consequences
there are compelling reasons for good ethical practice to of specific phenomenon namely price variation,
be an essential part of risk management. They discuss accidents, political hazards, disruption in supply of raw
that exploring the relationship of ethics and risk material, economic development, etc. Such risks
management has significant commercial outcomes. Not represent a wide spectrum of company’s risks that are
only those outcomes help to identify potential problems, dealt with by various specialists. In other word, effective
but they also help preventing fraud, preserving corporate risk management deals with market risks that the
reputation, and to mitigate litigation against company company is facing and tries to take advantage of
which lead to increased legitimacy. Likewise, Bhimani business opportunities that these risks might have. It is
(2009) say that risk management leads to higher an effective tool of contending with external market
corporate legitimacy. threats that are out of management control and result in
Using a sample of Chinese firms, Mua et al. (2009) reduction of profit variances (AliBaba and VazirZanjani,
examine the effect of risk management strategy over 2009).
performance of new product development. They find that The tools and facilities that management uses to face
risk management strategies that focus on technological, external market threats are financial hedging, insurance
organizational, and marketing factors, individually and contracts, management controls systems, transportation
interactively improve the performance of new product of resources and careful decisions that are made to
development. improve company’s profitability. All of the aforementioned
Gordon et al. (2009) examine the relation of enterprise movements are made to reduce adversity of situations
risk management (ERM) and performance. They argue that the company might face with.
that the relation of enterprise risk management and Currently to cover the market risks, companies do risk
performance is contingent upon five firm-specific factors management through derivatives via using insurance

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782 J. Econ. Int. Finance

coverage and through examining integrative risk exist for other company’s stakeholders like customers
management approaches. In addition, in comparison with and employees.
past risk management motivations, and historical In addition, in small companies that hold small portion
financial obligations, there is higher tendency to risk of capital market, there is little possibility for investors to
management now. Indeed, it is obvious that company’s change and update their investment portfolios. Because
accountability depends to its ability to utilize the new in such companies volume of stock supply will influence
opportunities that are derived from changes in the stock price and may lead to excessive decrease of
environment. price and cause stockholders a heavy loss. Therefore,
only stockholders of big companies are able to easily
change their portfolios (Andersen, 2008).
Risk management and performance If company does not pay enough attention to risk
management, this will affect its relationship with
When the company is able to prevent the undesirable stockholders and consequently harm business
effects of external risks and react to the environmental transactions. Company’s counter parties like suppliers
changes, it will be less sensitive to economic and customers demand higher premium for dealing with
consequences of market variation. In other words, when the company and this increases company’s cost of
the company effectively manages the risk, it successfully commercial transactions.
adapts to changes in environmental conditions and profit For example, suppliers may require company to pay
variation will be decreased (ParvizRad, 2002). According the cost of goods and services immediately or even in
to previous discussion, the following three reasons clarify some situations the suppliers expect advance payment
that better economic performances result from effective for goods and services that they offer. Furthermore, since
risk management. The three reasons will be discussed in employees think that the company is facing going
subsequently. concern problem, they are not fully committed to their
jobs and spend some time in search of new job. Based
(1) Less average rate of capital expenditures (Andersen, on the discussion so far there are higher costs in
2008) companies that do not manage their risks properly.
(2) Higher cost of contracts
(3) Increase in company’s specific investment
Increase in company’s specific assets
Less average capital expenditures When companies’ bankruptcy risk Increases, major
stockholders are not inclined to provide long-term
Profit stability reduces company’s business risk,
commitment to company and will cut relations and
increases repayment of debts and stabilizes going
resources that cause company’s appreciation. This is
concern. Furthermore, when company benefit from low
while the company’s specific assets are direct resources
risk, it will access higher borrowing resources and pays
of activities that enhance company’s profitability and
less interest expenses.
appreciation. Hence, if capital is used for other goals,
From owners’ point of view, when company decreases
then company will lose potential opportunities (Wang and
the risk of bankruptcy, the likeliness of reduction of paid
Reuer, 2006).
in capital decreases and company would have higher
For instance, when company is unable to establish its
expected future dividends.
past commitments in relation to other companies,
On the other hand, less variation of projects’ profitability
resources should be spent to other activities. Effective
may cause higher inducement of potential investors and
risk management decreases the probability of occurrence
consequently better availability of capital with less
of such conditions and lessens the imposition of losses
required rate of return. All these factors will lead to less
on stockholders.
average cost of capital from lenders and stockholders’
Therefore, risk management persuades stockholders to
equity. Also less financing costs will result in less interest
invest in companies specific assets. These resources
expense and better economic performance.
include processes of producing specific products or using
In other words, higher availability of capital can lead to
certain technologies in industries that use knowledge for
improvement of economic performance. The reason is
productions and services. In addition, such investments
that higher capital availability increases the available
that are caused by employees, suppliers, customers and
investment opportunities to the company.
partners are a kind of financial resource that are often
rare and valuable and are basis for higher economic
Higher contract costs value and gaining competitive advantage.
Therefore, total risk management reduces bankruptcy
Although, investors have reasonable chance of adjusting risk and decreases risk of company’s commitment to
and updating their portfolios, but such possibility does not customers, suppliers, partners, managers, employees,

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 Jafari et al. 783

etc. this lower risk will motivate institutional investors to development of company’s specific resources.
invest in companies specific assets that provide long- Furthermore, innovative business environments include
term value for company. industries with automatic technologies like computer
industries, measurement tool industries and
pharmaceutical companies. However, reliance on
Functional and performance behaviors advanced technology relates to specific assets of
companies whose stockholders are sure about usage of
Rezayian (2005) believes that the behavior is a set of knowledge in interaction with customers, suppliers,
activities that can be observed through performances and partners, managers and employees.
actions. Behavior management is an important issue in Moreover, knowledge based professional activities and
the management literature that is considered by services like auditing, consultancy, engineering, planning,
managers in administering affairs. and software processing, need proper investments in
Rahnamaye et al. (2007) believe that risk is a companies that support innovative behaviors and
probability of deviation of reported return from expected produce suitable and long lasting competitive advantage.
return that is derived from business objectives. Thus, to Accordingly, innovation brings about new products,
increase the efficacy that is frequency of achieving modern services and processes and introduces
predefined objectives, doing proper management seems constructive methods of doing business in organization.
necessary. If the consequences of management’s Continuous consideration to innovation will cause
behaviors and actions that are normally evident in commitment to research and development. Such
performance could be identified during decision-making commitment depends on incentive of major stockholders
process, then risk management quality would be and their motivation to invest in specific and unique
plausible. Meanwhile one of the salient methods through assets.
which consequences of management’s behavior can be Innovation is calculated as R and D costs occurred for
identified during decision making process is considering new products and services divided by total net sales. This
innovation. As a result innovation is very important in risk ratio is an independent variable in second hypotheses.
management. Therefore, from the theoretical perspective, Indeed, innovation is an attempt to develop new business
the connection between effective risk management and opportunities that generates a platform for competitive
performance, as representative for functional and advantage (Andersen, 2008). In addition, investment in
practical behavior, with regard to investment in innovation innovation provides diverse business opportunities and
and intellectual capital would be justifiable. boosts company’s flexibility (Chen and Xie, 2004). Thus,
the second hypothesis is as follows:

Knowledge, innovation and human capital H2: there is a higher positive relationship between total
risk management and the company’s performance level
Company’s weak reaction to external risks reinforces in companies that are investing in innovations.
likeliness of bankruptcy. Having such bankruptcy’s
prospect in mind, major potential stockholders avoid By developing and using specific, valuable, rare, unique
investing in companies’ assets that are useful for and sustainable resources, companies can improve
innovativeness along with company’s development and performance and have durable competitive advantage.
progress. Such competitive advantage depends on specific invest-
However effective risk management increases major ment that use innovations and do activities in industries
stockholders tendency to make long-term commitments. that have high growth and high knowledge which are
Such commitments are important for company’s valuation supported by human capital (Cohen and Kaimenakis,
(Hoyt and Liebenberg, 2008). Thus, the first hypothesis is 2007).
as follows: Obviously, the difference of the market and book value
is essentially caused by human capital potential value
H1: There is a meaningful relationship between total risk and its outcomes (Milost, 2007). Market-book ratio is
management and the company’s performance level. market value of outstanding stocks divided by the book
value of the firm and represents the effects of risk
The topic of combining different knowledge to obtain management performance in the company, which is
higher profit is considered as ability of company to namely based on human intellectual capital. Intellectual
combine its knowledge with other company’s knowledge capital could make large differences between market and
and global knowledge management. book value of assets and it is affected by future value of
Therefore, innovative companies who perform in the creative power of human knowledge.
industries with high knowledge like the computer As a result, in order to identify valuable and suitable
production or service industries are more concentrated resources of business, the company should have human
on advanced technology and have higher dependence on capital and knowledge as necessary precondition. In fact

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784 J. Econ. Int. Finance

Table 1. Description of variables.

Variable Type (IV, DV or CV) Description

Total risk Standard deviation of annual net sales over the standard deviation of
Independent
management economic returns

Net income (loss) divided by either average total assets or sum of equity
Performance Dependent
and long-term debts

Innovation Independent R and D expenditures over net sales

Market-book ratio Independent Market value of outstanding stocks divided by book value of firm
Firm size Control Logarithm of total assets
Financial leverage Control Long-term debt over total equity

the human capitals that are developed by communication Purposeful sampling is used for choosing samples. Companies that
initiate new ideas, and bring new paths to light that had following features are selected:
arrange market conditions (Boekestein, 2006).
(a) Financial statements and notes are available in the years of
Therefore, effective risk management could encourage 2003 to 2008.
major stockholders to invest in company’s assets that (b) Information about stock market prices of companies is available
earn higher benefits. In addition, higher value that high during 2003 to 2008.
growth companies and human capital based companies (c) They have R and D costs in the notes of their financial
give to innovation in company’s assets is because of statements.
effectiveness of total risk management (Manuel, 2007),
especially for the companies that are performing in active Therefore, after reviewing the information of all the companies listed
on TSE, only 52 companies from 13 different industries were
business environment. selected.
Thus the third hypothesis is defined as follows:

H3: there is a higher positive relationship between total Methods of data analysis and hypothesis testing
risk management and the company’s performance level
in companies that have higher level of intellectual capital. Testing hypotheses in this study is as follows: in the first hypothesis
the correlation between company’s performance level (dependent
variable) and total risk management (independent variable) will be
In this research the relationship between total risk examined, then in the second and third hypotheses, these two
management and the company’s performance level has variables will be tasted in presence of innovation (represented by
been investigated. Total risk management is calculated research and development costs) and intellectual capital
as standard deviation of annual net sales divided by the (represented by market-book ratio), respectively.
standard deviation of economic returns (ROA and ROI) Firm size that is measured by total assets may affect risk
and is averaged for 6 years. This ratio is independent management capabilities and company’s performance level.
Indeed, the companies selected for this study have not the same
variable in research hypotheses analysis. Since two total assets. Financial leverage that may be influenced by
different ratios were used for measuring corporate particulars of the industries in which the firm operates have effect
performance level, each hypothesis is tested separately on business risk and due to differences in the rate of long-term debt
with two different ratios of company performance (ROA by which the company is financed, two control variables; namely
and ROI). Table 1Error! Reference source not found. firm size and financial leverage were used in bivariate regression
analysis. Financial leverage affects business risk and is considered
indicates the summary of variables used in this study.
as a general risk management tool that affects risk management
effectiveness and performance. In fact, since taking a long-term
debt is one way of financing, firms always encounter risk of not
RESEARCH METHODOLOGY being able to pay their debt and interest on maturity date. Thus, the
more company has long term debt; the business risk is higher.
This research is exploratory-survey research that uses bivariate Financial leverage is measured as long-term debt over total equity
regression for testing the hypotheses. 6-year average level of and was included as a control variable in the regression analyses.
performance for ROA and ROI ratios as dependent variables and It should be noticed that company’s performance level variable will
total risk management, innovation and market-book ratios as inde- be tested separately in three research hypotheses with ROA and
pendent variables and firm size and financial leverage are ROI ratios.
considered as control variables. Firm size is natural logarithm of
total assets and is included in the regression analyses as a control
variable.
Samples were selected from companies listed in Tehran Stock HYPOTHESES ANALYSIS AND FINDINGS
Exchange during 2003 to 2008. The relevant data had been
collected from the companies’ financial statements and notes. Linear regressions were used to test the hypotheses. The

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 Jafari et al. 785

Table 2. The results of testing variables.

Hypothesis ANOVA result Regression model Variable R2 (%)

First hypothesis with total risk There is a y = performance level;
management (Risk ROA) and meaningful y = 0.456x + 0.111 19
performance level (ROA) relationship x = total risk management

First hypothesis with total risk There is a y = performance level;

management (Risk ROI) and meaningful y = 0.422x + 0.176 16
performance level (ROI) relationship x = total risk management

Second hypothesis with total risk There is a y = performance level;

management (Risk ROA) and meaningful y = 0.434x1 + 0.293x2 + 0.08 x1 = total risk management; 26
performance level (ROA) relationship x2 = innovations

Second hypothesis with total risk There is a y= performance level;

management (Risk ROI) and meaningful y = 0.422x + 0.176 16
performance level (ROI) relationship x = total risk management

y = performance level;
Third hypothesis with total risk There is a
y = 0.379x1 + 0.461x2 – x1 = total risk management;
management (Risk ROA) and meaningful 39
0.258 x3 + 0.089 x2 = intellectual capital;
performance level (ROA) relationship
x3= financial leverage

Third hypothesis with total risk There is a y= performance level;

y = 0.418x1 + 0.269x2
management (Risk ROI) and meaningful x1= total risk management; 21
+0.109
performance level (ROI) relationship x2 = intellectual capital

results showed a significant correlation between total risk in industries that have high growth levels and such
management and company’s performance. However, growth level is supported by human intellectual capital. In
since the R2 in the second and third hypotheses (by other words, the results showed that there is significant
applying innovations and intellectual capital) is higher positive relationship between functional behavior of
than R2 in the first hypothesis (which is regardless of management that is considered as their performance
innovation and intellectual capital), it has been concluded indicators and the total risk management that indicates
that investing on innovation and intellectual capital may activities and behaviors of directors. If management
improve company’s performance. The results of testing considers innovation and invention in their activities, the
hypotheses are presented in Table 2. company will certainly have higher levels of knowledge
and level of human intellectual capital will be improved.
Results show the effect of investment in innovations,
Conclusion research and development and intellectual capital on
corporate performance levels. Therefore, the results
In this research, the relationship between total risk notify managers of the importance of managing all kinds
management and the company’s performance level is of risks that company may face with. The results also
investigated. First, the results of hypotheses testing show that more investment in this field would improve
shows that there is a significant positive relationship corporate performance level, stabilize the profitability and
between performance level as a behavioral function and give more confidence to major investors to invest their
total risk management. If companies try to control resources in company. Finally, due to the impact of total
unfavorable conditions that result from exposure to risk, risk management on company performance, functional
they can improve corporate performance. behaviors of management should be considered in
Second, if companies invest in intellectual capital and investors’ decision making.
extend or create certain valuable, rare, unique and
unchangeable resources, they will have better per-
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