Financial Risk Management

Financial risk management is the process of identifying, analyzing and managing potential financial losses to protect a company’s stability.

All companies face a variety of risks. Scandals such as Enron, WorldCom, Tyco, and Adelphia, the tragic events such as 9/11, and the economic downturn associated with the U.S. subprime mortgage crisis have reinforced the need of companies to manage risk. Moreover, risk management should not be an after-thought, but instead should be a key element of any investment or financing decision.

Definition of Risk

There is no shortage of definitions for risk. We often refer to risk as the uncertainty regarding what may happen in the future. In some definitions, risk is distinguished from uncertainty, such that risk is uncertainty that can be quantified.

In everyday parlance, risk is often viewed as something that is negative, such as a danger, a hazard, or a loss. But we know that some risks lead to economic gains, while others have purely negative consequences. For example, the purchase of a lottery ticket involves an action that results in the risk of the loss equal to the cost of the ticket, but potentially has a substantial monetary reward. In contrast, the risk of death or injury from a random shooting is purely a negative consequence.

In the corporate world, accepting risks is necessary to obtain a competitive advantage and generate a profit. Introducing a new product or expanding production facilities involves both return and risk. When a company is exposed to an event that can cause a shortfall in a targeted financial measure or value, this is financial risk. The financial measure or value could be earnings per share, return on equity, or cash flows, to name some of the important ones. Financial risks include market risk, credit risk, market liquidity risk, operational risk, and legal risk.

The word “risk” is derived from the Italian verb riscare, which means “to dare.” Business entities therefore “dare to” generate profits by taking advantage of the opportunistic side of risk.

We can classify risks as:

• Core risks
• Noncore risks

The distinction is important in the management of risk. In attempting to generate a return on invested funds that exceeds the risk-free interest rate, a company must bear risk. The core risks are those risks that the company is in the business to bear and the term business risk is used to describe this risk.

In contrast to core risk, risks that are incidental to the operations of a business are noncore risks. To understand the difference, consider the risk associated with the uncertainty about the price of electricity.

For a company that produces and sells electricity, the risk that the price of electricity that it supplies may decline is a core risk. However, for a manufacturing company that uses electricity to operate its plants, the price risk associated with electricity (i.e., the price increasing) is a noncore risk. Yet changing the circumstances could result in a different classification. For example, suppose that the company producing and selling electricity is doing so on a fixedprice contract for the next three years. In this case, the price risk associated with electricity is a non core risk.

Sustainability Risk

In the past, the management of risks that a company faces has focused on its business and financial risks. The business risks include the sales risk-driven by competition and demand-and operating risks, affected by the structure of operating costs. The financial risks relate to the use of debt in the company’s capital structure.

In the past two decades there has been a broadening of the perception of risk to extend traditional business and financial risks to the complete spectrum of risk that a company faces that includes social and environmental responsibilities. This broad spectrum of risk is sustainability risk. For example, the social responsibilities of a company include labor and human rights, working conditions, training, governance, and ethics, whereas the environmental responsibilities include recycling and waste management, oversight, reporting, and resource use. Without effective management of these risks, a business risks the potential damages from boycotts, shareholder actions, lawsuits, and additional regulations.

The concept of sustainability has slowly gained prominence in the past two decades as investors, regulators, and companies grappled with the effects of corporate scandals, catastrophes, and tragedies. Many began to question whether the objective of the company as shareholder wealth maximization is too simplistic.

In other words, the question arises as to whether a company is valued considering not only its financial performance, but its environmental and social responsibility records as well. There is no definitive empirical evidence that the environmental and social dimensions of a company affect its value, but there is anecdotal evidence that investors may consider these dimensions.

As the issue of sustainability has grown in prominence, there has also been a surge of measures of companies’ sustainability risk, including the Institutional Shareholders Services Sustainability Risk Reports and the Deloitte Sustainability Reporting Scorecard.

In addition, indexes, including the Dow Jones Sustainability Indexes (DJSI) and the FTSE4Good indexes, have been created that track the performance of companies focusing on sustainability.

Further, many companies are now reporting their sustainability risk and risk management efforts to investors. For example, some companies now report on sustainability using the framework provided by the Global Reporting Initiative (GRI), though others develop their own reporting frameworks. Though GRI and other measures are still evolving, there is increasing pressure for some form of reporting on these risks.