Bancorp Treasury Services Limited

Make Risk Count.

PRACTICAL BUSINESS ADVICE

21 October 2009

Every business plan is wrong. Inevitably, not all its elements will materialise exactly as envisaged. Growth plans typically have less history as a guide, which lifts the levels of uncertainty involved. Plans must accept their own fallibility and be sufficiently flexible that deviations from the optimal path don’t derail the entire exercise or even, at worst, the whole organisation.

Recent wild movements in financial markets and in economic conditions generally have no doubt torpedoed many a plan and enforced a better appreciation of the need to find a comfortable place between certainty and flexibility. A common failing in planning is an insufficient recognition of the scale of potential changes. Business plans should therefore include a range of estimates and a number of scenarios, not merely a central case.

As far as financial market risks are concerned, there are two key variables that the plan needs to cater for. Whether considering funding costs of the envisaged growth or foreign currency conversions, the first variable is the quantity of the expected transactions. The second variable is the price of those transactions.

Consider funding. It is easy to be too optimistic, and underestimate the extent of support that may be required from your bankers. Funding facilities should have sufficient headroom to absorb a bigger amount and/or longer period than the core plan calls for. Funding alternatives such as factoring may be suitable.

Assuming the funds are committed and available, the actual cost of the debt needs to be controlled. Interest rates are likely to be on the rise at some point as economic recovery takes root. Finding the cash flow to service debt at 10% is a very different proposition to doing so at 6%. When, how fast and how far interest rates rise cannot be reliably forecast, and it won’t necessarily be a smooth transition. So, a proportion of the interest rate exposure should probably have the rate fixed or protected using interest rate swaps and/or options. This is especially so for the immediate year or two, or when cash flow is likely to be at its tightest due to a growth phase.

Similarly, foreign exchange rates can move fast and far enough that budgets quickly become way off. Even more than for interest rates, relying on forecasts as a basis for planning is a recipe for disaster. Instead, ask yourself “what if…?� and postulate a fair-sized move either way. How would the business cope with an exchange rate 10, or 20, cents higher or lower? Consider both how to protect against that risk and how to capitalise on opportunities.

Especially in current market conditions, explore the advantages of option-based solutions. When both volume and price are uncertain, options can be the ideal answer by providing protection without commitment.

Follow a 4 stage process for risk management: identify – quantify – manage – report.

If you need guidance on scenario planning, what financial tools are available and how they can work for you, talk to your advisor.

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