Risk management is now a critical task in many corporations. Any number of uncertainties can derail a strategic plan if they have not been anticipated. Sudden shortfalls in cash from operations can undermine a company's ability to follow through on valuable investment programs. In such cases management will consider emergency plans to raise funds by cutting dividends or turning to creditors and other outside sources, or it may decide to solve the problem by reducing their scale - perhaps even by shelving its strategic plan altogether. All these scenarios can have serious consequences for the company's future competitive position.
Providing the external resource of finance by both issuing new equity and/or company debt are more costly and difficult for mid-sized companies to achieve, as they lack the financial resources and market access of large companies. Recession, a shift in interest or exchange rates, or even a sudden cold snap could take a significant toll on their profits - perhaps even putting them out of business. They are likewise aware of their limited ability to control those risks by passing cost increases on to customers. There are two principal kinds of financial risk confronting mid-sized companies in general:
Repricing Risk, or the possibility that future debt will cost more or less than existing debt, a risk that increases with higher interest rate volatility;
Refunding Risk, or the possibility that a borrower will be denied access to money or capital markets as a result of an increase in leverage or external events that change the market's view of the industry or company.
Another characteristic of mid-sized companies is that they have typically large concentrations of equity, especially when the principal owners are the managers, as is often the case. The stockholders of such companies may not be well diversified and may have a substantial part of their (or their family's) net worth tied up in the business. In such a case, stockholders have a far stronger interest in reducing the volatility of corporate profits and firm value. Also important, to the extent that the firm uses debt financing, is greater cash flow stability resulting from active risk management, significantly reducing the possibility of financial trouble or bankruptcy. And finally, by protecting the firm's access to capital, risk management increases the odds that management will not be forced to pass up good investment opportunities because of capital constraints of fear of getting into financial difficulty. For all these reasons then, mid-sized companies are generally willing to explore their alternatives in controlling risk exposures.
Basic message is that corporate cash flows are influenced by the firm's risk profile. Its revenues, operating costs, financing costs and future investment opportunities will all be affected by the likelihood of financial distress, which in turn is a function of total risk. Consequently, even though finance theory maintains that reducing total risk will not lower the firm's required rate of return, it should lead to an increase in corporate cashflow, that will lead to an increase in corporate value. According to this, the purpose of corporate risk management is to eliminate the probability of costly lower-tail outcomes - those that would cause financial distress or make the company unable to carry out its investment strategy.
Likewise, my approach to risk management is to focus attention on ensuring that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities rather than reducing their scale or shelving their strategic plan. Risk management allows companies to stabilise their periodic operating cash flow by eliminating specific sources of volatility.
A well-designed risk management program creates value primarily by protecting the company's supply of funds and thus guaranteeing the resources necessary to carry out its strategic investment plan. In order to design an effective risk management program, managers need to address a difficult question. How large is the company's exposure to fluctuations in economic variables? In assessing a company's overall exposure, it is crucial to determine how fundamental economic variables facing the company are likely to affect not only its current operating cash flow, but also its future.
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