Guide for Identifying Financial Risks

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inance and treasury

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introduction

The type and extent o an organisations exposure to nancial risks will depend on the nature o its borrowings and its underlying

business. Analysis o the contractual maturity o debt or lending relative to projected net revenues will indicate the timing and

amount o mismatch in cash fows and thereore point to any potential interest rate risk. Where some or all o these cash fows are

denominated in oreign currencies, a oreign exchange risk will emerge.

This section broadly describes nancial risk categories and provides specimen questions that could help to show whether a

particular risk is relevant to an organisation. The answers provided by the organisations management will be helpul in constructing

an appropriate risk-management policy. The nancial risk categories typically managed by a treasury operation include:

liquidity risk

unding risk

interest rate risk

oreign exchange risk

commodity price risk

credit risk

operating risk.

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Liquidity risk is the risk that the entity will not have sucient unds available to pay creditors and other debts. This includes the risk

that loans may not be available when the organisation requires them or they will not be available or the required term or at anacceptable cost. There is also a risk that bank credit lines may be terminated i borrowers breach loan covenants. The organisation

may have to keep unused unding sources in reserve or potential outlays such as uture debt repayments, capital expenditure,

seasonal fuctuations, acquisitions and contingencies. Funding sources may include equity issues (in all orms), debt, supplier

nance and leasing.

Q

Has senior management reviewed a monthly cash fow orecast or the nancial year and has it been reconciled

to the operating plan?

Is the orecast regularly reviewed and revised where appropriate?

Are actual to variances reviewed and noted?

What capital expenditures are planned and how are they to be nanced?

I new unding needs to be included in the cash fow, is it committed or uncommitted, and have the banks or other sourceso unding been consulted and do they have enough inormation to give at least approval in principle?

Have extreme (unlikely but possible) scenarios been applied to ascertain weak points in the cash fow?

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Funding risk is most oten aced by highly rated large-volume borrowers who issue debt securities. These borrowers rely on liquidity

o their securities (the degree to which they are readily bought and sold in nancial markets) to maintain prices, smooth out pricevolatility and acilitate uture issues. The risk is that or some reason investors may judge the securities to be insuciently attractive,

with the result that prices may all and access to the market may become dicult.

For small organisations, unding risk exists in the extent to which they can rely on the support o their bankers and shareholders as

a substitute or issuing debt securities in the wider market.

Q

To what extent does the organisation rely on raising unds by issuing uncommitted securities into markets where lenders or

investors take a direct exposure to the organisation?

To what extent can or must the organisation rely on its bankers and shareholders to meet unding requirements instead?

To what extent does the organisations ability to issue at attractive prices into uncommitted debt markets, where the investor is

not acting as a broker or taking a principal position, depend on maintaining a high independent credit rating, a high-prole, well-

regarded name, continuity o issues, and signicant issue volumes, and encouraging investor support by satisying their needs?

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Interest rate risk is the risk that movements in variable interest rates will aect nancial perormance by increasing interest expenses

or reducing interest income. Changes in market rates o interest may also aect xed-rate securities where they are marked to

market, in which case the capital value o the securities will change.

Management needs to use sensitivity analysis to predict the impact on prot and loss o a given change in interest rates. The

substantial eect o volatile interest rates is demonstrated by experiences in the 1990s when variable rates in Australia suddenly

increased to nearly 20 per cent and then declined to less than 10 per cent.

Q

Does the organisation have any orm o borrowing or similar commitments or obligations that may be subject to a change in

interest rates? (Include conventional borrowing, overdrats, debtor or creditor terms and discounts, other contracts, etc.)

Are there loans to third parties or investments that have fexible interest rates? Are any income producing assets reliant on interest rates?

How concentrated is the timing o any interest rate resets?

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Foreign exchange risk describes the risk o variation in the rate o exchange used to convert oreign currency revenues and

expenses and assets or liabilities to Australian dollars.

Foreign exchange exposures are o three types:

transaction exposures resulting rom normal operational business activities (trade purchases and sales, short-term borrowing, etc.)

translation exposures resulting rom conversion o long-term oreign currency assets and liabil ities into Australian currency (equity

investments, capital items, etc.)

competitive exposures that may result (protably or otherwise) rom adopting a dierent approach to managing oreign

exchange exposures rom that taken by the organisations competitors

Where shareholder wealth is denominated in Australian dollars, a rise in the value o the $A relative to another currency has a

positive impact or oreign currency liabilities. This will reduce cost on conversion to Australian dollars and have a negative impact

on assets that reduce in value expressed in Australian dollars. Conversely, in the case o a all in the value o the Australian dollar,

the cost o oreign currency assets would increase.

Where there are assets and liabilities denominated in the same oreign currency (a natural hedge), the eect o a change in

Australian dollars will refect the net change in value.

Q

Does the organisation clearly identiy all oreign exchange exposures?

Are there any internal or natural hedges that will oset any impact on reserves or operating prot?

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CPA46549 11/06

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Commodity price risk is the risk that a change in the price o a commodity that is a key input or output o a business will adversely

aect nancial perormance. It should be noted that many commodities have a oreign exchange component in their $A price orexample, oil, gold and sugar.

Q

Does the organisation rely signicantly on specic commodities or inputs or outputs whose prices are determined

by the market?

Will price movements signicantly aect protability by increasing manuacturing costs or reducing sales proceeds?

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Credit risk is the risk that another party in a transaction will not be able to meet its nancial obligations. The general term credit

risk may include:

counterparty risk, which is the risk that the other party to a transaction will not meet its obligations as to timing or amount o

settlement

country/political/sovereign risk associated with government directives and policies that may aect the contractual perormance o

either party to the transaction, and that are generally beyond the direct control o the counterparty

settlement or delivery risk that may exist i there is a deault in a single settlement or delivery, in which case all other exposures or

positions with that counterparty will be closed out, thus establishing claims or transaction costs

Q

Has the organisation entered into any signicant nancial transactions which, in aggregate, amount to a material exposure to

any one counterparty, especially in one currency or one country?

Has the counterparty risk been assessed and accepted or each deal?

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Business or operating is the nancial risk generally associated with internal and external systems or the monitoring, negotiation

and delivery o nancial transactions. The risks are wide-ranging and can include natural disasters, human error, and breakdown o

nancial systems or ailure o electronic systems.

Q

Does the organisation have eective computer systems, processes and people to conduct and monitor the business?

Does the organisation have eective back-up and disaster recovery procedures or computers and systems used or accounting

and nancial administration, including treasury activities?

Does the organisation have eective personnel and human resources policies?

This act sheet series has been developed by CPA Australia. For urther inormation visit pl.m.
http://www.cpaaustralia.com.au/http://www.cpaaustralia.com.au/

Documents

Guide for Identifying Financial Risks