Measuring Cash Flow at Risk

The VAR methodology can be modified to measure what has been called Cash Flow at Risk (CFAR). The first step consists of delineating business exposures. The next step consists of setting up simulations to model the behaviour of key financial variables, commodity prices, exchange rates, and interest rates. The horizon selected needs to match that of the business planning cycle. Note that with longer horizons, the modelling of expected returns is increasingly important, justifying the use of simulation techniques. Finally, these financial variables need to be combined with a business cash-flow model. This is akin to attaching a simulation engine to the business cash-flow model. This approach can be generalised to all earnings, not just specific cash flows, in which case the risk measure is earnings at risk (EAR). Financial variables affect operating cash flows through quantities sold, sales revenues, the cost of goods sold, and other costs, as shown in figure above.

For instance, costs may be affected by commodity prices or, if imported, exchange rates. Sales revenues may be affected by exchange rates, if exported. This graphic model shows the need to model economic exposures, which represent the sensitivity of cash flows to movements in the price of the financial variable. Once this model is constructed, risk can be measured using the VAR of the operating cash flows.

Exposures can be complex. They depend on notional amounts as well as on the competitive environment in which the firm operates. Even more generally, there is no reason to focus on cash flows alone. Losses can occur if the value of inventories, or balance sheet positions, fluctuates due to financial variables. For some items on the balance sheet, such as commodity positions, this effect can be measured readily. For other items, this may be more questionable.

Unfortunately, the difficulty of performing a thorough cash flow analysis may lead firms to limit themselves to using rules of thumb, usually based on various coverage ratios. But coverage ratios do not tell a financial manager what is most important: the probability of cash insolvency associated with alternative risk profiles. This requires a series of cash budgets prepared assuming

• 1. Different economic conditions, and
• 2. The levels of usage of different risk-reducing mechanisms.

To do this properly the financial manager must specify an arrangement of likely future economic scenarios and how the firm's cash flows will be affected by these developments, with a probability attached to each scenario. Moreover, it is necessary to determine other possible sources of cash besides the cash flows from operations. These include liquid assets that can be drawn down, accounts payable that could be stretched, expenditures that could be deferred and assets that could be sold. The end result is a series of net cash flows that are or can be generated under each of the different economic scenarios. On the basis of the associated probabilities, the financial manager can then examine these cash flows and see whether a particular risk profile exposes the firm to too much financial risk. A useful place to begin the determination of an appropriate risk profile is to analyse what happens to a firm's cash flows under a "worst-case scenario". (Shapiro & Titman)

So, Shall We Use VAR or CFAR?

Value risk managers are concerned with the firm's total value at a particular point in time. A cash flow risk manager, by contrast, uses risk management to reduce cash flow volatility and thereby increase debt capacity. Thus value risk managers typically manage the risks of a stock of assets, whereas cash flow risk managers manage the risks of a flow of funds.

Many banks have used VAR techniques to help with strategic capital allocation decisions. Banks have the ability to use a complex tool to their business advantage. Non-financial corporations cannot employ similar tools. They can often measure cash flow-at-risk (CFAR). One of the purposes of using CFAR for firms is that equity investors may not care about absolute risks, but lenders do. High cash flow volatility restricts access to debt and may limit tax benefits and the ability to deploy scarce equity capital efficiently. Examining CFAR, we can alter the risk of cash flow that something we can control rather than something we cannot value.

However most would argue that CFAR is not necessarily the right measure of risk for the average corporation. This leaves many companies asking whether they can apply VAR concepts when they can measure only CFAR. Banks have not had to worry about this. Since bank portfolios are generally constantly marked-tomarket, a bank's VAR is also its CFAR. Any gain or loss in value immediately affects reported earnings and cash flow. According to this argument, the bank is in fact using VAR solely to calculate CFAR. (Shimko, 1998)

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