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.
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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.
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The AMA Handbook of Financial Risk Management
By John J. Hampton
AMACOMCopyright © 2011 John J. Hampton
All right reserved.
Chapter OneCategorizing 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.
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.
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.
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.
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.
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.
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.
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Table of Contents
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
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
Chapter 2 Appendixes 28
Chapter 3. Managing Operating Cash Flows 33
The Cash Flow Statement 33
Cash Flow Exposures 37
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
Chapter 4 Appendixes 73
Part 3. Analyzing Operating Risks 85
Chapter 5. Profit Planning 87
Breakeven Analysis 89
Profit-Volume Analysis 92
Marginal Analysis 93
Future Earnings per Share 95
Chapter 5 Appendixes 99
Chapter 6. Leverage 111
Return on Investment Leverage 111
Operating Leverage 116
Financial Leverage 118
Weaknesses of Profit Planning 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
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
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
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
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
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
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
Chapter 13 Appendixes 266
Chapter 14. Valuation of Business Combinations 271
Business Combinations 271
Takeover Strategies 276
Chapter 14 Appendixes 280