How to Utilize Financial Risk Management for Your Business
Businesses are not without risks. In fact, people who decide to go into business must reconcile with the fact that risks come part and parcel of the whole endeavor. The biggest concern of all businessmen and entrepreneurs as they go into business is, obviously, that of their venture failing, and failing spectacularly. While some are afraid that their business may not be profitable enough to sustain its continuous operations and growth, there are those who fear that their business may not even make it past the three- or six-month mark.
Mind you, even companies that have existed for years, even decades, are still constantly faced with different types of business risks. Just because the business has been operating for more than 5 or 10 years does not mean that it has developed an immunity against risks. It is possible that the organization employs effective risk management strategies, allowing the business to thrive and even grow.
Take note that the phrase “risk management” is used instead of, say, “risk elimination”. This is a clear indication that business risks will always be there, hanging over and around business organizations. What management and owners can do is to “manage” these risks – to mitigate or minimize the negative effects of the risks to the company and “soften the blow”, so to speak. They can be avoided, true, but they will always be there, posing varying degrees of threat to the business.
Therefore, one of the realities that entrepreneurs and anyone entering or starting a business must do is to accept that the risks exist, and they can never do away with them. The next thing is to identify the potential risks that the business will encounter in order to come up with strategies and plans to manage them.
There are five identified types of business risks. Strategic risk arises when the business plan or model is not followed, so that the business eventually loses its direction and loses sight of its organizational goals. The business will find itself having trouble attaining its objectives, and becomes less effective over time.
Compliance risk refers to the possibility that the business may not be obeying, or adhering to, applicable legislation and regulations in the conduct of its operations. A business decision, such as geographical expansions or extending the product line may put the business at risk of violating or not complying with specific laws.
The third type, operational risk, result from the failure of the organization’s internal processes and systems to carry out day-to-day operations. This could arise from incompetent employees, faulty business processes, obsolete technologies, and even natural and man-made disasters that directly impact the conduct of operations.
Reputational risk, on the other hand, refers to the risk that the reputation or image of the business will become tarnished or damaged, which will lead to a slew of other risks and problems such as loss of revenue, loss of customers, and distrust from partners and the business community.
The fifth type of business risk is financial risk, and it will be the focus of this discussion.
WHAT IS FINANCIAL RISK?
The first four types of business risk have financial repercussions. Strategic risk may result to the business spending on what was not planned, or outside the budget laid out in the business plan. The company may find itself being penalized and having to pay hefty fines due to non-compliance with certain laws and regulations. Failure in operations will also impact efficiency, especially when the company will be forced to increase its spending on damage control. Once the reputation of the business suffers, customers are likely to spend their money elsewhere, and investors may also pull out their investments.
While these effects are financial in nature, they are not strictly the “financial risks” that we are referring to.
Financial risks refer to those direct risks that arise from how the business handles the money flowing in and out of the business. It is also used to reflect the ability of the company to manage its debts and financial leverage. Another simple description for them is that they are risks posed by financial transactions.
Many people look at it simply as the possibility of suffering financial loss, and this can be brought on by various reasons, under various circumstances. Usually, the questions that are associated with financial risk include the following:
What (and who) are the main sources of revenue of the business?
What are the terms (credit period, interest rates) for sales made to customers on credit?
Which customers does the company extend credit to?
What is the current debt structure of the company? How much is short-term? Long-term?
What are the possible causes that give rise to financial risks? Let us take a look at some of them.
- Financial market instability. Generally, financial markets are volatile and unstable, and these could potentially result to losses for businesses and investors. This instability is often characterized by erratic movements of stock prices and currencies and fluctuation of interest rates.
- Economic factors. Countries’ economies and various industries may experience problems on a large scale, a classic example of which is when a recession happens. Businesses are likely to suffer financial losses when an industry-wide economic shift takes place, with the unstable behavior of supply and demand resulting to price drops, reduced production, and even weaker purchasing power of customers.
- External parties’ actions and decisions. Financial risks are also likely to arise due to the actions of external parties, such as vendors, suppliers, competitors and even customers. For example, a business will also suffer if the ability of its customers to pay their receivables to the company will be impaired. The inability to collect from customers is bound to spell considerable financial losses to the company.
- Internal actions (and inactions). Failures in the company’s internal processes, systems and workforce also have potential in increasing the organization’s exposure to financial risks. If employees refuse to do their jobs, this could lead to low productivity and, subsequently, low output levels. This means low inventory levels and lesser quantity to be sold, which eventually translates to lower income.
- Legal interventions. From time to time, governments come up with new laws, or update existing ones, that will have an impact on the financial aspect of the business. It may increase spending or costs that will lower the profit margin, or it may also influence the purchasing decision-making processes of customers, at the expense of the business.
From the foregoing, it is clear that financial risks can come from all directions, which makes avoiding or minimizing them even more imperative. Businesses should make it a point to manage these risks.
FINANCIAL RISK MANAGEMENT
Risk management in business is a very broad area, divided according to specializations or categories of risks involved. Financial risk management is one of them.
Financial risk management is the response or plan of action that an organization will implement to address the financial risks it is facing, and is likely to face in the future. It encapsulates the practices, procedures, and policies that will be used as guidelines on the acceptability of financial risks and their mitigation. In other words, management will make it clear what financial risks are acceptable to them through these policies.
Basically, a business will utilize financial risk management to forecast and analyze financial risks, and identify the procedures or actions that must be implemented in order to avoid them, or minimize their impact.
In Peter Christoffersen’s Elements of Financial Risk Management, he identified three major activities or stages:
- Identifying the financial risks, and their sources or causes.
- Measuring the level and impact of the financial risks and their effects.
- Determining plans and strategies to address the risks, and implementing them.
In addition to these three activities, financial risk management also involves continuous monitoring of the risks taken and taking careful note of the exceptions, if any. Analysis is also required, which means that documentation of the risks (and their results) must be prepared.
Businesses pour a lot of resources on its risk management initiatives, and the same goes with the matter on financial risk management. In fact, most businesses pay more attention on their financial risk management, considering how it impacts the financial aspect of the business.
ADAPTING FINANCIAL RISK MANAGEMENT IN YOUR BUSINESS
The application and usage of financial risk management in business is a huge and daunting task, which is why it is important to understand the best way to go about it.
The Financial Risk Manager (FRM)
Companies may organize their own financial risk management team from qualified employees within the organization. Large corporations have their own dedicated Risk Management Department, headed by a Chief Risk Officer, and with several units or divisions focused on the specific risks being managed. Certainly, another option, and one that has gained a lot of traction in recent years, involves seeking the services of independent risk management specialists.
The Financial Risk Managers (FRMs) are professionals that have the required certification to conduct financial risk management activities. They are the ones who are responsible for conducting the initial activities of the risk management process, specifically the identification of financial risks, the determination of acceptable financial risk levels, evaluation of the impacts or effects of these risks, and formulation of plans and strategies to minimize them.
What FRMs do NOT do, however, is to make the decisions on what strategy to choose, what policy to enforce, and even how much to invest. Those are the responsibilities of top management, who will only use the output of FRMs to guide them in their decision-making. They do not tell management what decision to make; rather, they equip and empower management to be able to make an informed decision.
Under the same principle, the FRM and the entire financial risk management team or department must adopt an attitude of independence from the company’s top management, or the people making the final business decisions. It is important to maintain independence in order to avoid potential conflicts of interest that will cloud the FRM team’s objectivity and management’s judgment.
The FRM Process
The Financial Risk Management process is not a one-time thing. It is an ongoing process, which is a given, since financial risks can come from all directions, at any time. Prior to starting the financial risk management process, there should be a clear understanding of the goals and objectives of the organization, since these will dictate the direction of the entire undertaking.
Step #1: Identify and prioritize the financial risks that apply to the business.
First, let us take a look at the most common types of financial risks that businesses are exposed to.
- Credit risk, or default risk, which arises from the inability of one party to pay or fulfill its obligations to another, such that they will be in default. If a company is unable to collect its receivables from customers, they will have poor cash inflow and lost income.
- Market risk, which arises from a decline in the market subsequently resulting to reduced or lost value of investments. If the assets of the business will decline in value, but all else remain the same, the net worth of the company will also decline.
- Liquidity risk, which arises when the assets or securities owned by the business cannot be immediately converted into cash when needed. This results to the business being in danger of defaulting on its obligations, such as making loan payments to creditors and dividend payments to the owners and investors. The owners or members of the board of directors may end up becoming personally liable for the debts of the business.
- Operational risk, which arises from problems or issues in the conduct of daily operations of the business, such as machine breakdowns, failure of business processes and manpower errors. Mistakes committed may result to considerable financial losses, and that is simply one of the many operational risks that businesses have to deal with on a daily basis.
- Interest rate risk, which arises from drastic changes in interest rates, particularly the sudden drops that lead to financial losses. This is often an offshoot of the market risk, since interest rates are directly affected by movements in the economy.
- Foreign exchange risk, which arises from movements in foreign markets. Foreign exchange rates of currencies will definitely have an impact on the earnings of a business with foreign operations or conduct foreign transactions.
Identification of the types of financial risks will make it easier for the company to make a detailed assessment and analysis of the specific risks that it is facing.
There are several ways for companies to identify and assess risks. Some of these processes are:
- Quantitative Risk Management. This is the detection, assessment and monitoring of financial risks in the financial transactions of a business using mathematical computations or evaluations. Usually, these calculations are for returns earned by the company on sales, investments and the like. Computations are also used on historical financial data for forecasting purposes.
- Risk and Control Assessment. This involves taking a look at the internal controls of the company when it comes to all its financial transactions. Generally, a weak internal control system will indicate high financial risks. For example, the lack of a reliable system of check-and-balance of sales and collections of payments will increase the risks that payments of receivables by customers will not be recorded properly, and the money will be misappropriated into the hands of the collecting employees.
- Financial Risk Audit. This is a process undertaken by businesses to assess that the company has adequate internal controls and policies, particularly in the accounting and reporting system. These will also pinpoint weaknesses in how transactions are recorded and accounted for.
After identifying the specific financial risks that are applicable in the case of the business, there is a need to prioritize or rank them according to the gravity of the risks and their potential effects. Usually, the risk that poses the bigger threats are those that are likely to result to higher financial losses (and even bankruptcy).
Step #2: Determine the level of risk tolerance of the organization.
If managers and employees are plagued by the presence of financial risks, every move they make, every decision and every action, will be guarded and laced with lack of confidence. One of the worst things that could happen is that they will always choose the safest route, “playing safe” in their business decisions, and letting promising opportunities pass by for fear that pursuing them will pose too much risk for the company.
Thus, there should be a predetermined level of exposure to risk that the company is willing to accept or tolerate. Setting this level will provide them room to move, so they can focus on value creation, knowing that they are still operating within acceptable bounds in terms of risk.
The factors to be considered when setting a threshold of financial risk are:
- Period or time horizon over which the financial risk is expected to take place. A company may find the risk to be greater if it is unable to collect its receivables over a three-year period than when customers are unable to pay within one year.
- Materiality. Cost-benefit analysis may show that certain costs are greater than the benefits derived from then. Generally, higher incurrence of costs is seen as more material and, therefore, more risky. A company may set a certain ceiling or maximum amount for its materiality level, meaning if the losses exceed that level, then it is material and, definitely poses high risk.
- Volatility of economic and financial environment. Businesses that are in an industry with a volatile nature, such as the banking industry or industries subjected to frequent fluctuations of costs and interests, may set lower thresholds for financial risk.
- Confidence levels of managers. This is largely personal, on the part of the members of management. Some managers are “braver” than others, so they have higher tolerance for risks, while businesses ran by largely conservative managers are bound to be more cautious.
There are several financial risk measures (or calculation methods) to arrive at a risk metric (the result that is being quantified). Examples of risk metrics are:
- Standard deviation of a company’s returns on investment, to measure volatility
- Estimated losses due to a debtor defaulting on his payments, to measure credit exposure
- Financial liquidity ratios, such as Current Ratio, Quick Ratio, Cash Ratio, and Asset Turnover Ratios, to measure liquidity of the company
Step #3. Formulate strategies to manage the risks.
This is where the business will identify the risk mitigation strategies that it will adapt to manage the financial risks it is facing. The choice of mitigation strategies largely depends on the specific risk that is being managed and the available resources to implement them.
Briefly, let us take a look at some of the most commonly used risk mitigation strategies for financial transactions, specifically for the different financial risks.
The company would want to improve its liquidity by ensuring it will always have enough funds to pay its debts as they fall due, as well as other operating expenditures.
- Identification of periods of slow and low cash inflows through various forecasting techniques, and planning cash budgets around them;
- Close monitoring of cash inflows and outflows on a regular basis (e.g. daily, weekly, bi-monthly or monthly);
- Performing aging of receivables regularly to monitor payment of debtor-customers to identify accounts that are already past due and take the necessary action to collect them;
- Sending communications or collection reminders to customers about their due amounts; and
- Maintaining a strong relationship with financial institutions, banks and other lenders that the business has obligations to.
As much as business would want to sell purely on cash basis, there are many that cannot do so, and have no choice but to also sell their products or services on credit. Problems may arise when the customers are unable to pay, leading to slow cash inflow and loss of revenue when the uncollectible amounts have to be written off as bad debts.
- Conducting thorough background and credit checks on customers before selling to them on credit;
- Establishing and imposing credit policies and terms and communicating them clearly (in writing, to be signed by both parties) to the customers before entering into a sale transaction;
- Maintaining a strong and positive relationship with debtor-customers to warrant being kept up to date on their liquidity status; and
- Monitoring of record of receivables of debtor-customers to keep track of their purchase and payment histories, so any irregularity can be seen as a warning, spurring the company to take preemptive action.
Interest Rate Risk
When the business relies heavily on borrowings for its operations, it is bound to be vulnerable to movements in interest rates, mostly through increase in interest expenses. Any interest income will also be reduced, resulting to even lower profits.
- Using a fixed rate when borrowing from a bank or financial institution to avoid fluctuations in regular interest expenses;
- Using a fixed rate when investing or lending, in order to ensure a fixed interest income amount;
- Management of exposure by using other bank products or financial instruments; and
- Maintaining a strong and positive relationship with the bank, financial institution or lender, and seek their advice or recommendations with respect to the interest rate exposure of the company.
Businesses may not be able to control the market, but they can at least try to minimize the negative financial impacts of movements in the market.
- Familiarization with the market to assess its potential and make forecasts based on patterns derived from historical data;
- Active gathering, updating, analysis and interpretation, and storage of market information, such as consumer trends and behavior and competitor presence, to name a few; and
- Close monitoring of movements in the market (through the conduct of market studies, following economic and business news, and utilizing market feedback mechanisms) to anticipate any activity that can potentially affect the financial aspect of the company.
Even the smallest decision regarding operations will have an effect on the financial stability of the company. Thus, operational processes and procedures must be viewed in consideration of possible financial impacts.
- Effective assignment and segregation of tasks to ensure that the right people are given the right job, and the possibilities of fraud and internal theft are reduced; and
- Close monitoring of budget execution or implementation, to ensure that the company is not spending excessively or, in contrast, underspending and lowering the quality of output.
Foreign Exchange Risk
Businesses would want, as much as possible, to minimize unexpected losses from fluctuations in the foreign exchange market, regardless of the size of the transaction. After all, a loss is still a loss.
- Actively taking on a buy-or-sell position on foreign currency and other similar options.
- Advanced buying or selling of foreign currency on transaction agreement date to take advantage of the spot rate and lock it in, avoiding any effect of a possible future drop in foreign currency rates;
- Maintaining a foreign currency account for proper matching of revenues and expenses in foreign currency transactions; and
- Seeking assistance from banks or other experts on how the business can maintain its foreign currency exposure.
Step #5: Implement the planned strategies.
The risk mitigation strategies must be enforced or implemented, but in accordance with policies established beforehand. This is where the plans and strategies are converted or transformed into actions.
Step #6: Track, measure, and refine.
The risk mitigation strategies implemented must be subjected to close monitoring in order to track their progress and ascertain whether they are effective or not. This is to enable them to control the risks, mostly by making the required adjustments in the areas where they are needed. It could be an adjustment of the operations or systems, or some other corrective action on the strategies or methods implemented.
As mentioned earlier, financial risk management – and risk management, as a whole – is an ongoing process. Therefore, it can be refined as deemed necessary. Monitoring should also be a continuous activity, with no room for complacency.
Step #7: Communicate and report results of the process.
At every step of the process, communication is very important. Top management should be kept in the loop throughout the conduct of the risk management process, especially since they are the ones to make the decision on what risk mitigation strategies to employ, and how to go about doing it.
Letting other members of the organization know about the company’s risk management initiatives is also highly recommended in order to encourage their trust in the company, and to boost their morale and motivate them to work harder towards the attainment of the goals of the organization.
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