Understanding the impact of inflation

With regards to the liquidity risk, it is important to understand P&L impact of the rising price levels, combined with the increased volatilities in interest rates and FX rates. For example, production companies may experience rising costs of goods sold while at the same time they might also experience increasing pressure on the sale prices due to FX rate movements.

Some important questions to ask are: What can be done to limit price increases on the supply side? Please, also refer to the article on the commodity risk management “Challenges to Treasury’s role in commodity risk management”. Can the price increases on the supply side be passed on to the customers? And, if so, what will be the overall impact on the profitability or EBITDA of the company?

Key financial metrics

The above outlines the added value of having an integrated framework for financial risk management. The starting point is for Treasury to establish what are the key financial metrics that need to be managed with regards to the firm’s overall financial performance. The basic distinguishment can be made between statutory accounting, management accounting and economic/competitive view on the firm’s performance. Statutory accounting view is focused on the accounting measures such as debt ratio, interest coverage and reported earnings. Economic view is focused on cash flows and metrics such as free cash flows are the focus. While accounting view tends to be more important for large publicly listed companies with credit rating obtained from credit rating agencies, economic view tends to be essential for privately held companies that are primarily finance though debt.

VaR modeling and scenario analysis

Once the key financial metrics are determined, the firm needs to develop thorough understanding of the financial exposures, correlations between the risk categories and their impact on the financial metrics of the company. Advanced financial modeling, such as Value at Risk (VaR) models, could be used to incorporate different types of financial risks and accommodate for the relationships and interdependencies between different risk categories. VaR models allow for the modeling of risks with imperfect correlations between one and another and allow modeling of multitude of possible outcomes. Next to the VaR models, it is also advisable for the firm to perform scenario analysis and stress testing where impact of economic downturn could be further modeled and analyzed. While VaR models provide output as a maximum dollar amount to be lost over a specified horizon at given confidence interval, scenario analysis provides a dollar amount expected to be lost under a specified scenario. Scenario analysis also allows for the Treasury to exercise an expert judgement in the definition of the potential scenarios and stress tests. Measuring the impact of the financial risks helps the firm to define its risk bearing capacity and indicate capital buffer required to withstand a specified period of the financial distress. For the organizations with imposed financial covenants, it is also important to execute prospective covenant testing including all relevant risk categories.

Risk appetite

After the potential impact of financial risks is measured, it is a role of the Treasury and the Board to define the risk appetite for the firm. Risk appetite can be defined as amount and type of risk that a company is able and willing to accept in pursuit of business objectives. Financial risk management or enterprise risk management teams should support Treasury and the Board with the definition of the company-wide risk appetite.

Finally, financial risk management policy and policies for the individual risk categories are formulated based on the risk appetite statement. These policies need to have stated objectives for managing of the financial risks, clearly set risk limits and clearly formulated hedging strategies.

Significant benefits

Integrated financial risk management framework requires significant effort, highly skilled resources and technological support. On the other hand, there are number of significant benefits that can be achieved, including:

• Integration of risk organization – top-down integrated framework that accounts for relationships and interdependencies of various risks.
• Integration of risk transfer – better risk reporting as holistic view of all risks can be taken and allowing only hedging of the residual risks that remain after factoring in for the diversification effect.
• Integration of business processes – optimization of business performance through business decisions such as capital allocation, investment evaluation and efficient allocation of resources (reducing risks and taking on most profitable risks).