Risky Business - How to Measure Financial Risk
CFOs are confronting an ever-expanding array of threats to their companies' financial health. From volatile markets to credit pitfalls, the landscape of corporate finance has become increasingly treacherous, demanding a new level of vigilance from those at the helm.
A recent Deloitte survey has thrown this shift into sharp relief, revealing that 70% of CFOs now rank risk management as a top priority for the coming year. The stakes, it seems, have never been higher.
Nick Fox, EY Partner and Transaction Diligence Leader, says: “Absolutely their job is to evaluate the risks that are facing that business, develop an understanding of the driver of the risk and its value, and then seek to implement strategies to manage the risk.”
Indeed, the benefits of such preparedness are manifold. Businesses with well-executed risk strategies report enhanced financial stability, more agile decision-making and a notable uptick in investor confidence.
A study by McKinsey & Company found that companies regularly conducting comprehensive risk assessments were 25% more likely to achieve their financial targets than those that did not. This statistic has not been lost on the biggest companies, which are increasingly employing advanced modelling techniques to inform their strategies.
Monte Carlo simulations, once the preserve of quants and academics, have now become commonplace in corporate finance departments. Stress testing, mandated for banks in the wake of the financial crisis, is being voluntarily adopted by firms across sectors, eager to prove their resilience to shareholders and regulators alike.
The rise of artificial intelligence in finance has been particularly noteworthy. An Accenture study found that 76% of banking executives believe AI will become the primary means of data interaction within the next three years. This technological revolution is reshaping how risks are identified, quantified, and mitigated.
How to conduct financial risk assessment
Nick says that CFOs “typically adopt a risk register with a traffic light system for evaluating risk. This would cover the full spectrum of risks ranging from the business-as-usual tactical-type decisions that you make to manage risk on a monthly basis, through to more strategic medium-term decisions about where to take the business to manage more fundamental risks such as the competitive landscape or developing technologies.”
First, CFOs need to understand the risks which are prevalent in whatever their business is and the market they face. Then they need to implement a risk control framework to manage those risks. And, from a financial perspective, have a budget or a plan and
track performance against KPIs and metrics to show if the risk is manifesting in the business in different ways.
Evaluating transaction risk
And then there are the risks involved in making a deal or closing a transaction, such as buying or selling a company.
When it comes to evaluating a risk on a transaction, a CFO undertakes due diligence to understand the risks and opportunities that a transaction presents them with. Often, they will bring in an external advisor to give them comfort and confidence in the numbers and help them evaluate the risks and opportunities, either costing the risk into the transaction price or contractually protecting themselves in share agreements.
Says Fox: “There are various risk management strategies which CFOs adopt, ensuring advice is taken such that risks are priced or effectively managed through the transaction documentation.”
A holistic approach
Fox believes that managing risk in a business requires a holistic approach, involving interaction across all members of the Board with the CFO sitting in the middle, interpreting these different risks as to how significant they could be financially.
Says Fox: “It's about having the right people in place, a good cadence and accountability for them to own those areas they are responsible for and a method of communicating clearly back to you as CFO, so you can drive appropriate strategies to manage these risks in the long-term.”
“Having the right attitude to risk throughout the organisation is not just the CFO's job, everybody has a role to play in that. When you put all these different disciplines represented at the Board together, you collectively set the strategic direction for the Company to navigate the various risks posed to the business which ultimately manifests in the reported financial performance of the business.”
As the business landscape continues to evolve, one thing remains clear: the role of the CFO has been irrevocably transformed. No longer mere number-crunchers, today's finance chiefs must be early-warning systems, capable of navigating the complex interplay between risk and opportunity.
In the rarefied air of the FTSE 100 or Fortune 500, those who can effectively balance prudent risk management with innovative financial strategies will undoubtedly emerge as the true architects of their companies' futures.
For the rest, the price of complacency may prove steep indeed.
To read the full story in the magazine click HERE
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