FINANCIAL RISK MANAGEMENT
Financial risk management is the process of evaluating and managing current and possible financial risks to decrease an organization’s exposure to risk. Financial risk management involves identifying the risk, measuring it, evaluating all possible remedies, developing a strategy, and then implementing the steps and financial instruments necessary to minimize potential ramifications.
A risk is defined as a possible event or circumstance that can have negative influences on the business. And hence a financial risk is a form of risk that arises from an event and has an adverse impact on the business’s financial condition.
Purpose of Financial Risk Management
Much as financial risk can realistically not be totally eliminated in a business, risk management is a beneficial financial management tool that;
- It helps the firm to coordinate and control necessary business data and processes.
- It provides a better understanding of the opportunity for performance measurement and profit sources.
- Links the company’s economic cycle with the factors of model risk.
Overview of Financial Risk management
Financial risks are generally constituted of four risk types, that is:
- Market risk.
- Debt and credit risk.
- Liquidity risk, and operational risk.
Market Risks involve the risk of changing conditions in the specific marketplace in which a company competes for business. One example of market risk is the increasing tendency of consumers to shop online. This aspect of market risk has presented significant challenges to traditional retail businesses in the Agricultural context.
Companies that have been able to make the necessary adaptations to serve an online shopping public have thrived and seen substantial revenue growth, while companies that have been slow to adapt or made bad choices in their reaction to the changing marketplace have fallen by the wayside.
This example also relates to another element of market risk: the risk of being out maneuvered by competitors. In an increasingly competitive global marketplace, often with narrowing profit margins, the most financially successful companies are most successful in offering a unique value proposition of their products that makes them stand out from the crowd and gives them a solid marketplace identity.
The most common types of market risks include interest rate risk, equity risk, currency risk, and commodity risk.
Interest rate risk
Interest rate risk covers the volatility that may accompany interest rate fluctuations due to fundamental factors, such as bank announcements related to changes in monetary policy. This risk is most relevant to investments in fixed-income securities, such as bonds which are considered risk-free investments for Agri-SMEs mostly because they operate in highly risky spaces.
Equity risk involves the changing prices of stock investments. This risk, therefore, applies to Agri-SMEs that have either gone public (through an Initial Public Offering) or are actively engaged in stock markets.
This is the risk of changing commodity prices of commodities such. Almost all Agricultural products are prone to commodity risk since prices for Agricultural produce change almost per season, or even several times during the same season!
Currency risk or foreign exchange-rate risk This arises from the change in the price of one currency in relation to another. It is usually incurred when a financial transaction is made in a currency other than the operating currency which is often the domestic currency of a business for example making a transaction in US dollars instead of the Ugandan shillings. The risk arises as a result of unfavorable changes in the exchange rate between the transactional currency and operating currency. Agri-SMEs that deal with multi currencies either through export, import or investment are subject to foreign exchange fluctuations which expose the companies to unpredictable realized losses arising from the negative effect on the value of assets, investments, and revenue streams.
This typically relates to the risk businesses face by extending credit or lending to customers. It usually arises when borrowers/customers fail to make the required payments. A business takes a credit risk when it provides financing of purchases to its customers, due to the possibility that a customer may default on payment. It is recommended that a customer’s creditworthiness be measured by the five Cs: credit history of the customer, capacity to repay, capital, the loan’s conditions, and associated collateral. Agri-SMEs are encouraged to establish functions solely responsible for assessing the credit risks of their current and potential customers before credits are offered.
This is a risk that occurs when a company has no cash to meet its financial obligations as and when they fall due. This can arise when for a certain period of time, a given financial asset, or commodity cannot be traded quickly enough in the market without impacting the market price or cash cannot be got when it’s needed despite ownership of assets.
General or seasonal downturns in revenue can present a substantial risk if the company suddenly finds itself without enough cash on hand to pay the basic expenses necessary to continue functioning as a business. This is why cash flow management is critical to business success and why analysts and investors look at metrics such as free cash flow when evaluating companies as equity investments. A company must handle its own credit obligations by ensuring that it always has the sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise, suppliers may either stop extending credit to the company, supplier relations will be negatively affected, and the company’s market price will be driven down due to the inability to implement post-paid contracts.
Operational risks refer to the various risks that arise from a company’s ordinary business activities. It summarizes the uncertainties and hazards a company faces when it attempts to do its day-to-day business activities the operational risk category includes lawsuits, horizon risk, fraud risk, personnel (employee) problems, and business model risk; which is the risk that a company’s models of marketing and growth plans may prove to be inaccurate or inadequate. Operational risks result from breakdowns in internal procedures, people, and systems as opposed to problems incurred from external forces, such as political or economic events, or inherent to the entire market.
Strategies to manage risks
Risks can be managed in mainly 3 steps; Risk identification, assessment, and treatment.
The first step in the risk management process is to identify all events that can negatively (risk) or positively (opportunity) affect the objectives of the business including business milestones, financial trajectory, timelines, and scope.
These events can be listed in the risk matrix and later captured in the risk register.
Risk is characterized by its description, causes, and consequences, qualitative assessment, quantitative assessment, and mitigation plan. Risk can also be characterized by who is responsible for its action (Risk owner). Each of these characteristics is necessary for a risk to be valid.
In order to be managed effectively, the risks identified must be as precise and specific as possible. The title of the risk must be succinct, self-explanatory, and clearly defined.
All members of the company can and should identify risks, and the content of these is the responsibility of the risk Owners. Risk Managers are responsible for ensuring that a formal process for identifying risks and developing response plans are conducted through exchanges of risk report forms with risk owners.
tools to help identify risks
- Analysis of existing documentation.
- Interviews with experts.
- Conducting brainstorming meetings.
- Using the approaches of standard methodologies.
- Considering the lessons learned from risks encountered in the past.
- Using pre-established checklists or questionnaires covering the different areas of the business (Risk Breakdown Structure or RBS).
There are two types of risk assessments; thus qualitative and quantitative.
A qualitative assessment analyses the level of criticality based on the event’s probability and impact.
A quantitative assessment analyses the financial impact or benefit of the event. Both are necessary for a comprehensive evaluation of risks and opportunities.
The Risk Owner and the Risk Manager will rank and prioritize each identified risk and opportunity by occurrence probability and impact severity, according to the business’s criticality scales.
Evaluating occurrence probability (P):
This is determined preferably based on experience, the progress of the business, or else by speaking to a risk expert. The level of probability is usually measured on a scale of 1 to 99%.
For example, suppose the risk that: “the price of soya will change in the next season” is 70% probable. This could be determined by historical price change analysis.
Evaluating impacts severity (I):
To assess the overall impact, it is necessary to estimate the severity of each of the impacts defined at a given business level. A scale is used to classify the different impacts and their severities. This ensures that the assessment of the risk is standardized and reliable.
The criticality level of risk or opportunity is obtained by the equation: Criticality = Probability x Impact
The purpose of the qualitative assessment is to ensure that the risk management team prioritizes the response on critical items first.
In most businesses, the objective of the quantitative assessment is to establish a financial evaluation of a risk’s impact or an opportunity benefit, should it occur. This step is carried out by the Risk Owner, the Risk Manager (with the support of those responsible for estimates and figures), or the financial controller depending on the organizational setup. These amounts represent a potential additional cost (or a potential profit if we are talking about an opportunity) not anticipated in the organizational budget.
For this, it is therefore necessary:
- To evaluate the additional costs incurred by financially reviewing:
- Hours of internal work.
- Hours of subcontracting.
- Additional work to do.
- Amendments and/or claims made to contracts.
- To calculate the cost of the undesired event’s consequences by adding these values.
This step will make it possible to estimate the need for an additional budget for the risks and opportunities of the project.
In order to treat risks, an organization must first identify its strategies for doing so by developing a treatment plan. The objective of the risk treatment plan is to reduce the probability of occurrence of the risk (preventive action) and/or to reduce the impact of the risk (mitigation action). For an opportunity, the objective of the treatment plan is to increase the likelihood of the opportunity occurring and/or to increase its benefits. Depending on the nature of the risk or opportunity, a response strategy is defined for the business. The following 7 strategies are possible:
7 Risk Response Strategies
- Accept: Do not initiate any action but continue to monitor.
- Mitigate/Enhance: Reduce (for a risk) or increase (for an opportunity) the probability of occurrence and/or the severity of impact.
- Transfer/Share: Transfer responsibility of a risk to a third party who would bear the consequences of the problem (share the benefits of a realized opportunity).
- Avoid/Exploit: Entirely eliminate uncertainty / take advantage of the opportunity.
Monitoring the progress of the treatment plan is the responsibility of the risk owner. They must report regularly to the risk manager, who must keep the risk register up to date.
Note: The cost of a risk mitigation plan must be integrated into the budget of the project.
Is a strategy to prepare for and lessen the effects of threats faced by a business. Comparable to risk reduction, risk mitigation takes steps to reduce the negative effects of threats and disasters on business continuity.
There are five general steps in the design process of a risk mitigation plan:
- Identify all possible events in which risk is presented. A risk mitigation strategy considers not only the priorities and protection of mission-critical data of each organization but any risks that might arise due to the nature of the field or geographic location. A risk mitigation strategy must also factor in an organization’s employees and their needs.
- Perform a risk assessment, which involves quantifying the level of risk in the events identified. Risk assessments involve measures, processes, and controls to measure the impact of risk.
- Prioritize risks, which involves ranking quantified risks in terms of severity. One aspect of risk mitigation is prioritization, accepting an amount of risk in one function of the organization to better protect another. By establishing an acceptable level of risk for different areas, an organization can better prepare the resources needed for business correspondence, while putting fewer mission-critical business functions on the back burner.
- Track risks, which involves monitoring risks as they change in severity or relevance to the organization. It’s important to have strong metrics for tracking risk as it evolves, and for tracking the plan’s ability to meet compliance requirements.
- Implement and monitor progress, which involves re-evaluating the plan’s effectiveness in identifying risk and improving as needed. In business continuity planning, testing a plan is vital. Risk mitigation is no different. Once a plan is in place, regular testing and analysis should occur to make sure the plan is up to date-and functioning well.
Types of risk mitigation strategies
There are several types of risk mitigation strategies. Often, these strategies are used in combination with each other, and one may be preferable over another, depending on the company’s risk structure. They are all part of the broader practice of risk management.
- Risk avoidance is used when the consequences are deemed too high to justify the cost of mitigating the problem. For example, an organization can choose not to undertake certain business activities or practices to avoid any exposure to the threat they might pose. Risk avoidance is a common business strategy used by many businesses.
- Risk acceptance is accepting risk for a given period of time to prioritize mitigation efforts on other risks. Almost all Agricultural activities involve some sort of risk acceptance.
- Risk transfer allocates risks between different parties, consistent with their capacity to protect against or mitigate the risk. One example of this would be crop insurance.
Risk monitoring is the act of watching projects and the associated risks for changes in the impact of the associated risks.
Risk can affect any combination of performance, cost, and scheduling; therefore, different strategies should be used to address risks based on the way they affect these factors. For example, it might be more important for a company to excellently implement a project than for it to save money in a certain project scenario. The company would likely employ a risk acceptance strategy, temporarily prioritizing risks that affect performance more heavily than cost.
Risk mitigation best practices
Below are some risk mitigation best practices that information security professionals should follow:
- Make sure stakeholders are involved at each step. Stakeholders may be employees, managers, unions, shareholders, or clients. All perspectives are important for developing a comprehensive, holistic risk mitigation strategy.
- Create a strong culture around risk management. This means communicating the values, attitudes, and beliefs surrounding risk and compliance from the top down. It’s important for every employee to have risk awareness, but the probability of a strong culture is greatly improved when management sets the tone.
- Communicate risks as they arise. Risk awareness must be strong throughout the entire organization, so facilitating communication of new, high-impact risks is important to keep everyone up to speed.
- Ensure the risk management policy is clear so employees are able to follow it. Roles and responsibilities should be clearly defined, and each defined risk needs a clear process for dealing with it.
- Continuously monitor possible risks. Risk monitoring practices should also be clearly defined and implemented to continuously improve the risk mitigation plan.