• Risks need to be measured to ensure they do not exceed the overall capacity of the business. This is particularly important when long-tail liabilities and financial markets’ volatility come into play. • Risks vary significantly in terms of reward and capital requirements; consequently, risk selection and prioritisation criteria are key to meeting business objectives. • Risks are interconnected and may influence each other: no adequate response can be designed without understanding the full picture. • Appropriate performance metrics and incentive systems are preconditions to healthy risk taking. • Building generous capital buffers is not sufficient as some risk types are impossible to quantify and require a highly specialised analysis of root causes and appropriate mitigating measures.
• Risks need to be measured to ensure they do not exceed the overall capacity of the business. This is particularly important when long-tail liabilities and financial markets’ volatility come into play.
• Risks vary significantly in terms of reward and capital requirements; consequently, risk selection and prioritisation criteria are key to meeting business objectives.
• Risks are interconnected and may influence each other: no adequate response can be designed without understanding the full picture.
• Appropriate performance metrics and incentive systems are preconditions to healthy risk taking.
• Building generous capital buffers is not sufficient as some risk types are impossible to quantify and require a highly specialised analysis of root causes and appropriate mitigating measures.
Effective financial risk management plays a key role in the creation of stable revenues from business activities, in particular in terms of stable funding and adequate hedging of external market risks. Conduct regular risk assessments so you are always aware of the risks to your business. Knowing your risks will help you assess the best options and create plans for risk mitigation.
• It is not sufficient just to assess the risks when starting a business. You need to assess them regularly so you are able to notice any newly-emerging risks and find the best ways to minimise them.
• By planning your risk responses in advance, you will be able to minimise any damage done to your business.
• Consider hedging against your risk if your suppliers or customers use foreign currencies. For example, if you have to pay your supplier in a foreign currency in 90 days, and you suspect the currency will appreciate, you should hedge against it. If the currency does appreciate you will not lose money because you have locked in the future rate with the hedge. In the same way, if it depreciates, you will not benefit, but you will not be worse off. This option helps you to plan cash flow more effectively and is usually available as a banking product, possibly incurring a fee.
Stress testing is a tool that can improve your risk management and raise the level of confidence in business planning and forecasting. It is a complex activity which requires pulling together knowledge, competencies and infrastructure across the business.
• Stress testing is essentially forecasting to model cash burn rates, cash reserves and facility headroom.
• Before testing, determine your objectives and the business case for stress testing.
• Make sure your stress testing includes both quantitative analysis and business judgement.
• Incorporate large counterparty shocks (such as your main suppliers going out of business or your largest customer ceasing to do business with you) to evaluate the impacts of concentration.
Establish economic metrics that are simple and adaptable to challenging environments. Use these metrics as KPIs for future testing. Ensure stress testing is refined continuously based on new intelligence and risk identification, such as the crisis lasting longer than expected or customer and supplier disruption.
• Do not fully rely on the stress metrics you have calculated for normal business operations when your business enters a challenging environment. In times of disruption, it is natural that your business will exceed the metrics you have planned, and trying to stay within them may provide unnecessary pressure in an already difficult situation. Monitor them only to understand how far your business is deviating from the normal time stress tests in reality. Make sure you explain this hybrid approach to stakeholders in normal times so that the steering approach you will take during challenging environments is clear to them.
Types of risk
There are different types of risks to your finances. The most common and distinct financial risks include credit risk, liquidity risk and operational risk.
Credit risk arises principally from the business loans and receivables presented under financial fixed assets, trade and other receivables, cash, and the positive fair value of derivatives. Offering your customers credit means providing goods and services without immediate pay. Depending on your bilateral agreements, your customers will have a certain amount of time to pay you for goods or services. Allowing your customers to buy on credit will generate more sales, as it will help your customers with their liquidity management.
Credit risk is a risk that one party to the agreement will cause a financial loss for the other party by failing to meet its obligations. If your customers are not able to pay for the goods or services you provided, or are late with their payments, it could have potential consequences for your business operations and cash flow.
• When giving your customers credit, your business takes on the credit risk associated with customer default.
• You need to be prepared for possible defaults and make sure that your cash flow is not dependent on expected receivables.
• It is important that businesses understand the credit risk of each customer. If a customer has a higher credit risk, they should be offered less favourable credit terms.
• Credit risk characteristics may be different depending on credit terms. Approach and assess each customer individually.
Do as much as you can to minimise the risk. To learn more about working capital and credit risk management, see here.
A business’s liquidity is measured by the time a business needs to get to cash. There is market liquidity and operational liquidity. Market liquidity refers to how fast a business can sell certain assets if it finds itself in immediate need of funds. Operational liquidity refers to everyday operations and the cash the business has for these.
• Not being able to convert assets into cash is considered a liquidity risk.
• A business that does not hold liquid assets is risking having to sell those assets at below the market price in the case of an emergency.
Managing liquidity risk is very important for your business. Liquidity risk is unavoidable, so it is essential that your business manages it successfully. Your business should monitor its cash position by using successive liquidity budgets. On the other hand, management needs to ensure that the cash position is sufficient to meet the financial obligations towards creditors and to stay within the limits of loan covenants.
• Management of liquidity risks should include:
— measurement and monitoring
— identifying assets with high levels of liquidity risk, such as land and buildings, which are usually high-valued and hard to sell in a short amount of time
— emergency planning for liquidity
— implementation of a stress-testing plan
— design or adjustment of models of deposit base stability (including models of stability in stressed conditions) and implementation of replication portfolios
— reviews and validations of the models and methodologies used.
Business should always be aware of their liquidity risk. By comparing assets and liabilities, you can forecast how much money you might owe if something goes wrong and compare it to the available assets and their liquidity. Define scenarios that address global slowdowns and model cash flow.
• Small businesses are less likely to have a lot of liquidity in everyday business. Make sure that your business has a buffer to fall back on. Include various trigger-based moves in each scenario to prepare appropriate responses and reactions and assure stabilisation of the business.
• Identify variable and semi-variable cost elements in your cost structure.
Operational risk refers to your potential inability to cover your operational expenses. Unlike credit risk and liquidity risk, operational risk does not come from revenue changes but from unexpected business activities. To learn more about operational risk and how to manage it, follow this link.