AC 422(Financial Risk Management)

Lecture/Tutorial 2

Financial Risk Management

• Dr. Luis R. Alamil, CPA, FFA-Aus., Ph.DBA
Course Facilitator
• Miss Jennifer Sigl
Tutor
 Background
• “Genuine risk management makes a neutral,
well-informed assessment of the risk the
business entails. It looks for ways to shed or
mitigate the unwanted risks; and retain and
manage only the risks that are necessary or
desirable to take.”
 Chapter 2:Learning Outcomes
1. Discuss your understanding on the nature and purpose of
financial risk management.
2. Relate financial risk management from the general
concept of risk management.
3. Explain the context of Modern Portfolio Theory.
4. Discuss the role of a financial risk manager and the
different types of financial risk management; and the
different asset classes’ strategies.
5. Cite and explain the different approaches to the risk
management.
6. Cite and discuss the different types of financial institutions
and the corresponding financial risk they are experiencing.
 LOI 1:
Discuss student’s
understanding on the nature
and purpose of financial risk
management.
a. Financial Risk
 Financial Risk
• Generally relates to the odds (probabilities) of
losing money.
o the possibility that a company's cash flow will
prove inadequate to meet its obligations.
o Can also apply to a government that defaults
on its bonds.
o Corporations also face the possibility of
default on debt they undertake but may also
experience failure in an undertaking the
causes a financial burden on the business.
 Financial Risk-Goverments’ side
• The possibility of a government losing control
of its monetary policy and being unable or
unwilling to control inflation and
defaulting on its bonds or other debt issues.
o Governments issue debt in the form of bonds and
notes to fund wars, build bridges and other
infrastructure and pay for their general day-to-day
operations.
o The U.S. government's debt—known as Treasury
bonds—is considered one of the safest
investments in the world.
 Financial Risk
• Common forms:
• Credit risk,
• liquidity risk,
• asset-backed risk,
• foreign investment risk,
• equity risk, and
• currency risk
• Investors can use a number of financial risk
ratios to assess a company's prospects.
 Financial Risk
• Financial risk refers to business' ability to manage
debt and fulfil financial obligations.
• Financial risk is a type of danger that can result in
the loss of capital to interested parties.
• For governments, this can mean they are unable to
control monetary policy and default on bonds or
other debt issues.
• Corporations also face the possibility of default on
debt they undertake but may also experience
failure in an undertaking the causes a financial
burden on the business.
 Financial Risk
• Examples:
• 1. The banking industry is required by regulators to
manage its operational risk, which is the risk of
hazards such as terrorism, losses caused by nature,
computer viruses and hackers, fraud, etc.
• 2. There are also risks associated with processing
transactions and risks associated with liquidity where
markets can dry up and almost cease to function at
the very time when an entity needs to sell an asset.
• 3. There are also risks associated with legal,
accounting, tax, and regulatory matters that would
not, in a strict sense, be viewed as financial risks.
 b. Nature of FRM

• Financial risk management (FRM) is a process

describing the practice of identifying, measuring,
and controlling the financial risk carried by an
organization.
 Why call it Financial Risk Mgt.?

• Answer:
• All risks have financial consequences,
particularly in a business, government, or non-
profit organization.
 Why call it Financial Risk Mgt.?
• Some risks are viewed as financial risks and
others as non-financial risks.
• Example:
o In a manufacturing firm, the risk of factory
accidents is typically viewed as a non-
financial risk.
o The risk of a product recall is usually viewed
as a non-financial risk.
• But both of these events have enormous
financial impacts.
 c. Purpose of FRM
• Main purpose:
• To protect economic value in a firm by managing
exposure to financial risk - principally
operational risk, credit risk and market risk, with
more specific risk variants, as faced by the firm.
• Specific purpose:
• To identify sources of risks,
• To measure risks,
• To plan how to address risks.
 LO 2:
Relate financial risk management
from the general concept of risk
management.
 Relation of Risk Mgt with Financial Risk Mgt
• Risk Management • Financial Risk Mgt
• the process of identifying, • a process describing the
assessing and controlling practice of identifying,
threats to an organization's measuring, and controlling
capital and earnings; the financial risk carried by
• stemming from a variety of an organization.
sources • a function within
o (including financial organizations that aims to
uncertainties, legal detect, manage, and hedge
liabilities, technology issues,
strategic management
exposure to various risks;
errors, accidents and natural • stemming from the use of
disasters. financial services.
 Relation of Risk Mgt with Financial Risk Mgt
• Risk Management • Financial Risk Mgt
• examines the relationship • Involves an assessment of
between risks and the various assets and liabilities in
cascading impact they could the present as well as in the
have on an organization's future.
strategic goals. o Match various kinds of
future income streams and
• A holistic approach to payment obligations.
managing risk is sometimes o Example, raising funds for
described as enterprise risk investment or working capital
management requirements, paying wages
o emphasis on anticipating and invoices, provisioning for
and understanding risk future payment obligations
like pensions, and so on.
across an organization.
 Relation of Risk Management with Risk
Management
• Risk management is the process of identifying,
assessing and controlling threats to an organization's
capital and earnings. These risks stem from a variety
of sources, including financial uncertainties, legal
liabilities, technology issues, strategic management
errors, accidents and natural disasters.
• Financial risk management is a function within
organizations that aims to detect, manage, and
hedge exposure to various risks stemming from the
use of financial services.
 LO3:
Explain the context of Modern
Portfolio Theory
 The Modern Portfolio Theory
• Financial risk management as a science can be
said to have been born with modern portfolio
theory particularly as initiated by Professor
Harry Markowitz in 1952 with his article,
"Portfolio Selection".
• The modern portfolio theory (MPT) is a
practical method for selecting investments in
order to maximize their overall returns within
an acceptable level of risk.
 The Modern Portfolio Theory
• A mathematical framework used to build a
portfolio of investments that maximize the
amount of expected return for the collective
identifying its sources, measuring it, and the
plans to address them.
• A key component of the MPT theory is
diversification.
 The Modern Portfolio Theory
• Most investments are either high risk and high
return or low risk and low return.
• Markowitz argued that investors could
achieve their best results by choosing an
optimal mix of the two based on an
assessment of their individual tolerance to risk
 LO4
Discuss the role of a financial risk
manager and the different types of
financial risk management; and the
different asset classes’ strategies.
 Role of Financial Risk Manager
• Main:
• Make sure to consider the various factors affecting
financial risk.
o Take into account both external and internal factors
when carrying out a financial risk assessment.
• Factors:
• External factors - including economic downturns,
market rates, industry changes, law changes, etc.
• Internal factors - including underperformance, poor
cashflow management, bad investments, new
competition, staff issues, etc.
 Role of Financial Risk Manager
• identify and measure the risks
• decide on the level of risk the business is willing to
accept
• consider insurance to protect against business risk
• identify potential issues with cash flow
• review financial arrangements with creditors
• Take necessary measure (care) if extending credit
to customers
• diversify r income sources
• regularly reassess business risks
 Different asset classes’ strategies
• An asset class is a group of investments with
similar risk and return characteristics.
• One way to diversify your portfolio is to invest
in different asset classes.
• As risk in a portfolio increases, there is greater
potential to earn higher returns. But the risk
comes with a greater chance of losing money
Different asset classes’ strategies
Different asset classes’ strategies
 LO5:
Cite and explain the different
approaches to the risk
management.
Approaches to the risk management
 L06:
Cite and discuss the different types
of financial institutions and the
corresponding financial risk they are
experiencing.
 Financial Ratios to Spot Companies Headed
for Bankruptcy
• While investors evaluate equities using several
different analytical perspectives, including
profitability ratios, income ratios, and
liquidity ratios, they should be careful to
include financial ratios that can specifically be
used to provide early warning signals of
possible impending bankruptcy.
 Financial Ratios to Spot Companies Headed
for Bankruptcy
• There are key ratios that can provide such
warnings well in advance, giving investors
plenty of time to dispose of their equity
interest before the financial roof falls in.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Current Ratio
• The current ratio, which simply divides current
assets by current liabilities, is one of the primary
liquidity ratios used for evaluating a company's
financial soundness.
• It evaluates a company's capability of handling
all its short-term debt obligations, by measuring
the adequacy of the company's current
resources to cover all of its debt obligations for
the next 12 months.1
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Current Ratio
• A higher current ratio indicates that the
company has more liquidity.
• Generally, a current ratio of 2 or higher is
considered healthy.
• A ratio of less than 1 is a definite warning sign.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Operating Cash Flow to Sales
• Cash and cash flow are key to the success and
survival of any business. The operating cash
flow to sales ratio—operating cash flow
divided by sales revenues—indicates a
company's ability to generate cash from its
sales.
• The ideal relationship between operating cash
flow and sales is one of parallel increases.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Operating Cash Flow to Sales
• If cash flows do not increase in line with sales
increases, this is cause for concern, and it may
be an indication of inefficient management of
costs or accounts receivables.
• As with the current ratio, generally speaking,
the higher this ratio is, the better. Analysts
prefer to see improving, or at least consistent,
numbers over time.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Debt/Equity Ratio
• The debt/equity (D/E) ratio, a leverage ratio, is one of
the most frequently used ratios for evaluating a
company's financial health.
• It provides a primary measure of a company's ability to
meet financing obligations and of the structure of a
company's financing, whether it comes more from
equity investors or more from debt financing.
• If this ratio is high or increasing, it indicates the company
is overly dependent on financing from creditors as
opposed to capital provided by equity investors.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Debt/Equity Ratio
• The ratio is also important because it is one of
the factors considered by lenders. If lenders
believe the ratio is getting uncomfortably high,
they may be unwilling to extend further credit to
the company.
• An optimal D/E ratio is about 1, where equity
roughly equals liabilities. Although the D/E ratio
varies between industries, the general rule is that
a ratio higher than 2 is considered unhealthy.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Cash Flow to Debt Ratio
• Cash flow is essential to any business. No
business can operate without the necessary
cash to pay bills; make payments on loans,
rentals, or mortgages; meet payroll; and pay
necessary taxes.
• The cash flow to debt ratio, calculated as cash
flow from operations divided by total debt, is
sometimes considered the single best predictor
of financial business failure.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Cash Flow to Debt Ratio
• This coverage ratio indicates the theoretical
period that it would take a company to retire
all of its outstanding debt if 100% of its cash
flow was dedicated to debt payment.
• A higher ratio indicates a company is more
soundly capable of covering its debt.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Cash Flow to Debt Ratio
• Some analysts use free cash flow instead of cash
flow from operations in the calculation because
free cash flow factors in capital expenditures.
• A ratio higher than 1 is generally considered
healthy, but any value below 1 is commonly
interpreted as signaling impending bankruptcy
within a few years unless the company takes steps
to substantially improve its financial condition.
Financial Ratios to Spot Companies Headed for
Bankruptcy
• Cash Flow to Debt Ratio
• Another metric often used to predict potential
bankruptcy is the Z-score, which is a
combination of several financial ratios used to
produce a single composite score.
 What Financial Ratios Determine
Bankruptcy?
• There are a handful of financial ratios that can
help determine if a company is heading
toward bankruptcy.
• These include:
1. gross profit margin,
2. cash flow to debt ratio,
3. debt to equity ratio, and
4. current ratio.
What Financial Ratios Do Creditors Look At?

• The financial ratios that creditors look at are:

1. the cash flow to debt ratio,
2. the quick ratio, and
3. the debt to service coverage ratio.
 What Debt/Equity Ratio Is Considered
Bankruptcy Risk?
• A debt/equity ratio of 2 or higher is
considered to be indicative of a company that
may end up bankrupt.
• The higher the number, the more the
company has in liabilities than assets, which
means it is relying on its debt over its equity,
which is risky.