finance and treasury

Guide for identifying financial risks

Introduction
The type and extent of an organisations exposure to financial risks will depend on the nature of its borrowings and its underlying business. Analysis of the contractual maturity of debt or lending relative to projected net revenues will indicate the timing and amount of mismatch in cash flows and therefore point to any potential interest rate risk. Where some or all of these cash flows are denominated in foreign currencies, a foreign exchange risk will emerge. This section broadly describes financial 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 helpful in constructing an appropriate risk-management policy. The financial risk categories typically managed by a treasury operation include: liquidity risk funding risk interest rate risk foreign exchange risk commodity price risk credit risk operating risk.

CPA Slate Blue 5405(CMYK) Liquidity risk is the risk that the entity will not have sufficient funds available to pay creditors and other debts. This includes the risk A4P RIM that loans may not be available when the organisation requires them or they will not be available for the required term or at an
Liquidity risk
acceptable cost. There is also a risk that bank credit lines may be terminated if borrowers breach loan covenants. The organisation may have to keep unused funding sources in reserve for potential outlays such as future debt repayments, capital expenditure, seasonal fluctuations, acquisitions and contingencies. Funding sources may include equity issues (in all forms), debt, supplier finance and leasing. Questions Has senior management reviewed a monthly cash flow forecast for the financial year and has it been reconciled to the operating plan? Is the forecast regularly reviewed and revised where appropriate? Are actual to variances reviewed and noted? What capital expenditures are planned and how are they to be financed? If new funding needs to be included in the cash flow, is it committed or uncommitted, and have the banks or other sources of funding been consulted and do they have enough information to give at least approval in principle? Have extreme (unlikely but possible) scenarios been applied to ascertain weak points in the cash flow?

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Guide for identifying financial risks

Funding risk
Funding risk is most often faced by highly rated large-volume borrowers who issue debt securities. These borrowers rely on liquidity of their securities (the degree to which they are readily bought and sold in financial markets) to maintain prices, smooth out price volatility and facilitate future issues. The risk is that for some reason investors may judge the securities to be insufficiently attractive, with the result that prices may fall and access to the market may become difficult. For small organisations, funding risk exists in the extent to which they can rely on the support of their bankers and shareholders as a substitute for issuing debt securities in the wider market. Questions To what extent does the organisation rely on raising funds 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 funding 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-profile, wellregarded name, continuity of issues, and significant issue volumes, and encouraging investor support by satisfying their needs?

Interest rate risk

Interest rate risk is the risk that movements in variable interest rates will affect financial performance by increasing interest expenses or reducing interest income. Changes in market rates of interest may also affect fixed-rate securities where they are marked to market, in which case the capital value of the securities will change. Management needs to use sensitivity analysis to predict the impact on profit and loss of a given change in interest rates. The substantial effect of 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. Questions Does the organisation have any form of borrowing or similar commitments or obligations that may be subject to a change in interest rates? (Include conventional borrowing, overdrafts, debtor or creditor terms and discounts, other contracts, etc.) Are there loans to third parties or investments that have flexible interest rates? Are any income producing assets reliant on interest rates? How concentrated is the timing of any interest rate resets?

Foreign exchange risk

Foreign exchange risk describes the risk of variation in the rate of exchange used to convert foreign currency revenues and expenses and assets or liabilities to Australian dollars. Foreign exchange exposures are of three types: transaction exposures resulting from normal operational business activities (trade purchases and sales, short-term borrowing, etc.) translation exposures resulting from conversion of long-term foreign currency assets and liabilities into Australian currency (equity investments, capital items, etc.) competitive exposures that may result (profitably or otherwise) from adopting a different approach to managing foreign exchange exposures from that taken by the organisations competitors Where shareholder wealth is denominated in Australian dollars, a rise in the value of the $A relative to another currency has a positive impact for foreign 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 of a fall in the value of the Australian dollar, the cost of foreign currency assets would increase. Where there are assets and liabilities denominated in the same foreign currency (a natural hedge), the effect of a change in Australian dollars will reflect the net change in value. Questions Does the organisation clearly identify all foreign exchange exposures? Are there any internal or natural hedges that will offset any impact on reserves or operating profit?

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Guide for identifying financial risks

Commodity price risk
Commodity price risk is the risk that a change in the price of a commodity that is a key input or output of a business will adversely affect financial performance. It should be noted that many commodities have a foreign exchange component in their $A price for example, oil, gold and sugar. Question Does the organisation rely significantly on specific commodities for inputs or outputs whose prices are determined by the market? Will price movements significantly affect profitability by increasing manufacturing costs or reducing sales proceeds?

Credit risk
Credit risk is the risk that another party in a transaction will not be able to meet its financial 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 of settlement country/political/sovereign risk associated with government directives and policies that may affect the contractual performance of either party to the transaction, and that are generally beyond the direct control of the counterparty settlement or delivery risk that may exist if there is a default in a single settlement or delivery, in which case all other exposures or positions with that counterparty will be closed out, thus establishing claims for transaction costs Questions Has the organisation entered into any significant financial 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 for each deal?

Business or operating risk

Business or operating is the financial risk generally associated with internal and external systems for the monitoring, negotiation and delivery of financial transactions. The risks are wide-ranging and can include natural disasters, human error, and breakdown of financial systems or failure of electronic systems. Questions Does the organisation have effective computer systems, processes and people to conduct and monitor the business? Does the organisation have effective back-up and disaster recovery procedures for computers and systems used for accounting and financial administration, including treasury activities? Does the organisation have effective personnel and human resources policies?

This fact sheet series has been developed by CPA Australia. For further information visit cpaaustralia.com.au
CPA46549 11/06