The AMA Handbook of Financial Risk Management

The AMA Handbook of Financial Risk Management

by John Hampton

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Overview

In this indispensable book from the industry-leading American Management Association, financial expert John Hampton offers game-changing tips for dealing with the most important areas of financial decision-making. Filled with strategies, principles, and measurement techniques, The AMA Handbook of Financial Risk Management shows readers how to categorize financial risks, reduce risks from cash flow and budget exposures, analyze operating risks, understand the interrelationship of risk and return, manage risks in capital investment decisions, determine the value of common stock, and optimize debt in the capital structure. Engaging and detailed explanations and practical applications enable anyone involved in the financial management of an organization to recognize the factors at stake and the solutions that would produce the best organizational outcomes. Managing financial risk boils down to understanding how to reduce a complex business environment into workable concepts and models. This strategic guide shows you how to make these individual decisions with the big picture in mind.

Product Details

ISBN-13: 9780814417447
Publisher: AMACOM
Publication date: 04/20/2011
Pages: 320
Product dimensions: 7.25(w) x 10.25(h) x 1.13(d)
Age Range: 18 Years

About the Author

JOHN J. HAMPTON is a professor of business at St. Peter's University, and former Executive Director of the Risk and Insurance Management Society (RIMS). A respected speaker, he regularly addresses professional audiences on technologies that comprise the cutting edge of risk management.

Read an Excerpt

The AMA Handbook of Financial Risk Management


By John J. Hampton

AMACOM

Copyright © 2011 John J. Hampton
All right reserved.

ISBN: 978-0-8144-1744-7


Chapter One

Categorizing Financial Risks

THE ENTERPRISE RISK MANAGEMENT FRAMEWORK

Financial risk management is developed within a framework of enterprise risk management. In this section, we discuss that framework.

Enterprise Risk

This is defined as the variability of risks and opportunities when firms conduct business operations. It is a double-edged sword, as it focuses on both an upside and a downside. The focus is:

Missed opportunities. The failure to undertake a business venture when it provides economic value possibilities at an acceptable level of risk • Financial losses. The exposures that arise from business operations that can cause losses to current economic value

Financial risk is a subset of enterprise risk that encompasses the financial consequences, both good and bad, of managing enterprise risk and pursuing opportunities.

Enterprise Risk Management

A modern approach to understanding enterprise risk is to examine it in the context of enterprise risk management (ERM), one of the most popular and misunderstood of today's important business topics. ERM addresses the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives. ERM encourages organizations to identify relevant events, developments, and circumstances; assess them in terms of likelihood and magnitude of impact; develop a strategy to reduce risk or seize opportunity; and monitor the progress toward objectives. This process is designed to protect enterprises from harm and create value for owners and other stakeholders.

ERM tells us that there is a new world of risk. No longer is risk management largely limited to the isolated silos of production, distribution, marketing, and segmented lines of business or business units. We do not assume that the chief marketing officer is responsible for the financial exposures and opportunities in the marketplace anymore than the chief financial officer is accountable for financial risks. The risk picture is incomplete when it is limited to the individual components of an organization. This realization encourages new approaches to assess an organization's appetite for risk, avoid unacceptable exposures, and seize opportunities.

Business Risk

ERM is rapidly replacing earlier approaches to risk management. Many risk discussions start with the term business risk, which has a variety of definitions, including:

• Risk associated with the unique circumstances of a particular industry or competitor in a market • A situation, the result of either internal conditions or external factors, that may have a negative impact on the profitability of a given company • The possibility of a destructive shift in the data, assumptions, and analysis that are used in planning for the employment of assets to achieve financial goals

Sometimes the definitions contradict each other. As an example, one definition refers to the possibility of loss inherent in a firm's operations and environment that may impair a firm's ability to achieve adequate returns on its investment. The proponents of this definition go on to define financial risk as exposures arising from the use of debt or the creation of other liabilities. With these definitions, total corporate risk becomes the combination of business risk and financial risk. This contradicts the other definitions, where financial risk is a subset of business risk.

Addressing Financial Risk

Organizations have two ways to address risk. The wrong way is to assume that people can understand hundreds or even thousands of exposures. This is not possible. Risks and opportunities must be organized and accepted at various levels by risk owners. A brief overview of the new ERM includes the following specific features:

Upside of risk. Most people discuss risk as the possibility of loss. This is totally insufficient, as risk also has an upside. A lost opportunity is just as much a financial loss as damage to people and property. This is a key insight. Ask the ancient Chinese warrior Sun Tzu or the fictional Godfather character Michael Corleone. • Alignment with the business model. A business model is a framework for achieving goals. Within it, each manager supervises a limited span of subordinates, functions, or subsidiaries. The manager also oversees a limited number of risks and initiatives. ERM encourages us to align the hierarchy of risk categories with the business model. • Risk owners. Just as someone is accountable for revenues, profits, and efficiency in each organizational unit, a single person should be responsible for each category of risk. When questions arise, we should not be dealing with a committee or multiple individuals. We should go directly to the risk owner. However, some risk assessments must be shared. Exposures arising from the culture, the leadership, or even the reputation of the organization should be assessed using collaboration among key executives and the board. • Central risk function. Although risks cannot be managed centrally, organizations need a central risk function. Its role is to scan for changing conditions from a central vantage point and share the findings with the risk owners. This approach recognizes that risks cross units and responsibilities, and that critical risks and opportunities can easily be missed in the day-to-day operation of a business. In a change from traditional thinking, organizations should consider creating a central risk function that, by itself, does not have any responsibility for risk management. Risk goes with the risk owners. Risks that cross units or responsibilities are identified centrally and dealt with using customized solutions. Just as the internal auditor identifies and reports noncompliant procedures but does not suggest how to correct them, the central risk function identifies and shares its findings. • High-tech platform. ERM encourages the use of new technologies to clarify risks and opportunities. We now have the capability to tie together the whole story of risk from the top to the bottom of the organization. We can show the relationships visually, isolate key factors, and prepare reports on the status of the exposures we face and the opportunities we pursue. Technology is a friend of risk management.

RISK CATEGORIES

Like so many concepts in a complex modern organization, the term financial risk management conjures up various responses. What does it mean? Is it limited to financial risks, such as excessive debt or a shortage of cash? Does it cover business interruption, product-liability lawsuits, or natural disasters that affect operations? How does it differ from corporate finance, where the chief financial officer seeks to increase the value of the firm and achieve required returns suitable to the risk of investments? Finally, is financial risk management the sole purview of the CFO? Are production, marketing, administration, and other executives exempt from the discussion?

Financial risk management encompasses the tools that we use in the framework of enterprise risk management. The tools are part of the planning process as firms develop strategies for creating economic value. They assist in decision making as companies assess risk and seize opportunity.

This approach to financial risk is fundamentally different from earlier definitions. Financial risk management recognizes that every business decision has an upside and a downside. Thus, risks are viewed as being in the realm of uncertainty that can have favorable or unfavorable outcomes. Within this framework, managers identify a variety of exposures and opportunities under the umbrella of financial risk.

Categorizing Financial Risks

Enterprise risk management encourages the organizing of risks and opportunities into a hierarchy that matches the business model of an organization. One structure creates the following categories:

Production. The creation of the goods and/or services sold or distributed by the organization • Marketing. Efforts to reach customers or clients or to identify or develop markets for products or services • Cash flows. Management of cash flows from operations, investment of capital, and creation of an appropriate return on invested assets • Compliance. Aligning activities with legal and regulatory requirements and processes • Technology. Dealing with changes in assets and systems that provide information and communications • Business disruption. Preparing for negative events that slow or cease a business's operations and taking steps to return to normal activity

We can illustrate the structuring of risks by stepping down one level below each category.

Production Risk

Assigned to a chief production officer but shared on the high-tech platform, the exposures and opportunities in this area cover risks such as:

Design. Does production coordinate with marketing, finance, legal, and others to develop the right products or services that meet the needs of all parties? • Supply. Does the organization have policies and procedures to mitigate disruption risks with respect to components or inputs? • Process. Is the organization employing the best practices for creating products or services and ensuring that they meet quality and other standards? • Efficiency. Are best practices being used to control costs and improve the productivity of people, assets, and systems?

Production Risk at Phillips, Nokia, and Ericsson. Sometimes the financial consequences of a "relatively small" incident can prove to be quite substantial. An example is what happened after a Phillips N.V. semiconductor fabrication plant in New Mexico was struck by lightning in March 2000. The bolt started a small fire that was quickly extinguished. Nobody was hurt, and damage was quite minor. However, the problem for a few of Phillips's clients, notably Nokia and I.M. Ericsson, was that the plant was the only source of microscopic circuits for their cell phones. In fact, 40 percent of the plant's production went to these two companies. As shown in Figure 1-1, the financial risk in their production area was a lack of redundancy in a channel for components for a key product. Trays of wafers were destroyed, and production was interrupted.

After the fire, Phillips alerted 30 customers that a fire had taken place and production had been stopped. Phillips told the customers that it estimated a one-week time delay to clean up the facility and start production. Nokia ignored the estimate. After demanding to know all details of the incident, Nokia identified the disruption as a critical risk and pulled out all the stops to find alternative suppliers. Nokia was successful. Even though the disruption extended much longer than one week, Nokia experienced virtually no delay in its production and shipping of cell phones.

Ericsson had a very different experience. Lower-level employees did not tell the head of production about the delay for several weeks. By the time Ericsson sought other sources of supply for microchips, Nokia had contracted for all spare capacity.

It was a small incident at another company that created significant financial losses. Phillips experienced losses of between $1 and $3 million after collecting $40 million from business interruption insurance policies. Nokia had minor additional expenses, which were offset by a small rise in market share as it made sales to former Ericsson customers. Ericsson suffered big time, incurring a loss in excess of $2 billion. Within a year, the company was forced to withdraw from the mobile phone market.

Lesson Learned. Financial risk management needs to incorporate production risk exposures and opportunities.

Production Risk Complexity at Dell. A second story shows the complexity of a system used by Dell Computer. It involves Dell, Intel, and Toshiba. Dell used Intel's Pentium processor to power its personal computers in a multistep production process. Toshiba Ceramics grew silicon and sliced it into wafers in Japan. Intel etched the wafers in a semiconductor lab in Oregon and then shipped the etched wafers to be packaged in an assembly plant in Malaysia. The packages were finally shipped to a Dell plant in Ireland, where they were inserted into computers. Such a system had multiple places where a disruption could cause short-term or even long-term financial risk.

Production Risk at Ford Motor. A third story was an actual disruption that occurred at Ford Motor Corporation in the fourth quarter of 2001. Following the September 11 attack on the World Trade Center in New York City, U.S. airports were closed for a short period of time, but U.S. borders were closed for much longer. Ford experienced a 13 percent drop in U.S. production in the fourth quarter because trucks carrying components for automobile and truck manufacturing were stopped at the Mexican and Canadian borders.

Visualizing Production Risk. Some people argue that it is difficult to foresee the kind of production risks that disrupted the businesses of Ericsson and Ford and could have affected Dell. Financial risk management seeks to identify scenarios where such exposures can be recognized and mitigated. Figure 1-1 shows a view in a high-tech platform where the CEO can see all the way down a risk structure to the issue of multiple suppliers. Avoiding sole suppliers for critical components and creating redundancy in a supply chain are examples of financial risk management.

Marketing Risk

The second category of financial risk involves marketing exposures and opportunities. Examples of subrisks are:

Customer needs. Do we have an understanding of what potential customers will buy based on their real or perceived desires to purchase? • Distribution. Do we have efficient and redundant channels for moving a product or service from creation through a channel to a final customer or client? • Volume. Are we likely to sell sufficient units to justify the original investment of capital and provide an adequate return given the risk undertaken? • Pricing. Do we expect the firm to obtain an adequate price to cover variable and fixed costs, including financing charges, and provide an adequate return on invested capital?

Example: The Upside and Downside of Marketing Risk. As an example of a financial risk management approach to marketing risk, consider a firm that has a choice of two different selling prices that create two different forecasted levels of sales. A quick financial calculation shows the earnings before taxes with each set of data. Once the numbers have been calculated, the decision makers can consider the risk involved with raising the price. Will it scare off buyers? They can also consider the opportunity. Will buyers perceive higher quality so that the higher price produces greater sales? Figure 1-2 shows the data and answers.

Answer: The lower price produces higher earnings before taxes under the original assumptions. With a bad reaction to the higher price, the downside reduces earnings by about one-third. With a positive perception of quality, earnings are expected to jump by more than 60 percent.

Cash Flow Risk

The next subcategory of financial risk management involves having adequate cash to support production, marketing, and other areas of the firm. A number of subcategories can be identified within cash flow risk.

Organizational Cash Flows. Cash comes from many sources, and the balancing of cash receipts and disbursements can be a highly technical task. Figure 1-3 shows cash as being at the center of dealings with owners, creditors, production, marketing, and distribution. As can be seen from the figure, other sources and uses of cash can also affect cash flow. A firm may have autonomous subsidiaries, such as Japanese operations or the ownership of an unrelated business. Such an entity can provide cash flow to a parent company or can get into trouble and require cash infusions. Key initiatives are another liquidity concern. A firm can start a project and begin pumping money into it. Or it can discover a new source of cash.

(Continues...)



Excerpted from The AMA Handbook of Financial Risk Management by John J. Hampton Copyright © 2011 by John J. Hampton. Excerpted by permission of AMACOM. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Table of Contents

Contents

Preface xi

Introduction xv

Part 1. Introduction to Financial Risk 1

Chapter 1. Categorizing Financial Risks 3

The Enterprise Risk Management Framework 3

Risk Categories 5

Financial Risk Management 14

Conclusion 16

Part 2. Accounting, Cash Flow, and Budget Exposures 17

Chapter 2. Risks from Financial Accounting 19

Overview of Accounting 19

Accounting Principles 19

Categories of Accounts 21

Trial Balance 24

Financial Statements 25

Conclusion 28

Chapter 2 Appendixes 28

Chapter 3. Managing Operating Cash Flows 33

The Cash Flow Statement 33

Cash Flow Exposures 37

Conclusion 40

Chapter 3 Appendixes 40

Chapter 4. Operating Budgets 53

Nature of Budgeting 53

Forecasting Revenues 54

Life-Cycle Stages in Budgeting 57

Risks in Revenue Forecasting 60

Expense Allocations 63

Accounting Budgets 66

Cash Budgeting 67

Details of Budgeting 70

Conclusion 72

Chapter 4 Appendixes 73

Part 3. Analyzing Operating Risks 85

Chapter 5. Profit Planning 87

Planning 87

Breakeven Analysis 89

Profit-Volume Analysis 92

Marginal Analysis 93

Future Earnings per Share 95

Conclusion 99

Chapter 5 Appendixes 99

Chapter 6. Leverage 111

Return on Investment Leverage 111

Operating Leverage 116

Financial Leverage 118

Weaknesses of Profit Planning 121

Conclusion 121

Chapter 6 Appendixes 122

Chapter 7. Financial Analysis 129

Ratio Analysis 129

Liquidity Ratios 132

Profitability Ratios 136

Other Ratios 138

Determining Financial Norms 142

Conclusion 142

Chapter 7 Appendixes 143

Part 4. Relationship of Risk and Return 149

Chapter 8. Time Value of Money 151

Short-Term Financing 151

Intermediate-Term Financing 155

The Amortization Schedule 157

Conclusion 161

Chapter 8 Appendixes 162

Chapter 9. Risk and Required Return 171

Nature of Risk 171

Capital Asset Theory 178

Risk and Required Return 181

Financial and Operational Risks 183

Conclusion 186

Chapter 9 Appendixes 186

Part 5. Nature of a Capital Investment Decision 193

Chapter 10. Capital Budgeting Cash Flows 195

Foundation of Capital Budgeting 196

Cash Flows 201

Conclusion 207

Chapter 10 Appendix 208

Chapter 11. Capital Budgeting Returns 211

Payback Method 211

Present Value Techniques 212

Internal Rate of Return Method 213

Net Present Value (NPV) Method 215

Midyear Discount Factors for Cash Flows 217

Conclusion 221

Chapter 11 Appendixes 221

Part 6. Factors That Affect the Value of a Firm 233

Chapter 12. Valuation of Common Stock 235

Common Stock and Equity Markets 235

Valuation Concepts 237

Value of Common Stock 240

Comparative Approaches to Valuation 244

Conclusion 245

Chapter 12 Appendixes 245

Chapter 13. Capital Structure of the Firm 253

Capital Structure 253

Weighted Average Cost of Capital (WACC) 254

Required Return at the Margin 257

Contribution of Miller and Modigliani 260

Optimal Capital Structure 263

Conclusion 266

Chapter 13 Appendixes 266

Chapter 14. Valuation of Business Combinations 271

Business Combinations 271

Pyramiding 273

Takeover Strategies 276

Conclusion 280

Chapter 14 Appendixes 280

Index 293

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