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FD Report: Financial Risk Management

By their very nature, and as has been writ large in recent years, shocks to the financial system can easily produce a deadly domino effect. The financial crisis that began in a niche corner of the US mortgage market in 2008 did not take long to cascade through the financial services industry before contagion spread into the wider economy, hitting all business sectors.

One of the lessons learned, often the hard way, is that businesses – even those widely regarded as successful – are often only one shock away from failure. In the financial services industry, often the first to bear the brunt of an unexpected and unprecedented financial catastrophe, previously respected and successful companies such as Lehman Brothers and American International Group unravelled rapidly.

Other household names have suffered. Metro-Goldwyn-Mayer, the legendary film studio famous for classic movies such as The Wizard of Oz, is set to file for bankruptcy. Closer to home, in September, property services giant Connaught entered administration in the biggest UK bankruptcy since Woolworths in 2008.

Perhaps even more surprising was the collapse of another building group, Rok, which went into administration only weeks after its chief executive Garvis Snook trumpeted an agreement to provide building repair and claim management services to Tesco Underwriting’s home insurance customers.

Finance directors spend countless hours deriving the perfect business strategy, only to be thrown off kilter by an unanticipated financial shock.

In the case of Rok, the company suffered a cataclysmic fall in revenue, driven largely by its public sector clients cutting back on contracted building work. Because Rok had a fixed cost base, this severely squeezed cashflow. Neil Morling, chief financial officer at built asset consultancy EC Harris, agrees that having a fixed cost base can prove challenging in times of economic stress.

Flexibility and agility

“The big financial risk we face is the volatility of our top line and our relatively fixed cost base,” Morling tells Financial Director. “We have tried to turn our resource base into a more flexible model. We have developed a more agile working policy. We now encourage people to work directly with the client and to work from home. The idea is to reduce the cost of our infrastructure.”

Richard Pennycook, group FD at FTSE-100 supermarket operator Morrisons, is even more acutely aware of the need to keep tight cost control when uncertainty looms large.

“The big risk for us is the devaluing of sterling and volatility in commodity prices,” Pennycook tells Financial Director. “For a lot of those, we have hedging programmes in place using instruments to hedge forward currency and forward commodity movements.”

Trade credit insurance

“Beyond the obvious banking risk, one of our key financial risks is trade credit insurance. That is a big ticket for us,” Pennycook adds. “That is a stakeholder retailers weren’t used to managing.”

For Arif Kamal, group FD of chartered surveyor and planning consultant GL Hearn, market liquidity risks have translated into unique financial risks.

With banks reluctant to lend, Kamal says it is vital to maintain a solid relationship with his company’s banking partners.

“The economic climate is very challenging because our client base is two thirds in the retail sector,” Kamal says. “The retail sector depends on bank lending. That will have an impact on the business because they will not want to invest in new projects.”

Kamal says that only by having accurate records can a business know if it has a cashflow issue. Only by regularly monitoring is it possible to create appropriate budgeting plans based on the demands of the client base. These predictions can be used to plot the progress of the business and highlight any financial issues that need attention before they become real problems.

“We look at key performance indicators on a month-by-month basis. We look at the competition and what they are doing. That allows us to identify the main risks involved and analyse and evaluate those risks,” Kamal says.

The demise of the likes of Rok and Connaught provides stark evidence of the distressed state of the construction industry. However, Kamal feels that GL Hearn has acquitted itself well during the current financial shockwave.

“The key is good cash management,” he says. “When Lehman Brothers erupted in 2008, every business looked at its cost base. We did a similar thing. You have to take a look at everything you do – your strategy, lines of business.”

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