Blueprint for Financial Strategy, Part 2: A Risk Framework Approach
The first article in this series, “A master plan for the financial strategyDescribed how the financial community is being invited to become more and more strategic. In my experience, however, we don’t often stop to wonder what exactly this means. There are two areas where I think the finance function can bring real added value to the company’s strategy: first, the strategic choice, because the face of the most risky companies must be analyzed through a risk framework. Second, strategy without the ability to measure the value it creates (or destroys) is a hit in the dark. Traditional accounting tools are very limited in their ability to measure value directly, but there is a simple and straightforward process that allows us to do this if we are willing to think outside the box.
We have the toolkit, we just need to use it in a different way
The challenge of combining strategy and risk
Probably the reason why you don’t very often see strategy and risk getting married in a formal way is that the risks that arise from the strategy are often difficult to assess and assess in financial terms. The risks arising from the strategic choice are often unlimited and multidimensional. At the same time, our nature as financial professionals does not lend itself to dealing with the inevitable uncertainty that comes from analyzing a business strategy. Finance people measure, calculate and draw conclusions from data. Even though this data is a forecast for the future, we tend to treat its veracity with some respect. So how do we overcome this?
It is crucial that the financial community develops the ability to move away from its traditional mindset and think a little differently. We have the toolkit, we just need to use it in a different way. In the context of strategic risk, the challenge is to become comfortable with explaining uncertainty. While it may seem like unfamiliar territory, remember that if the business is considering the strategy, it is already considering the associated risks. The company must be able to get a sense of the impact of these risks on the bottom line. The confidence, the desire and the expertise to do this must be present within the company and if not, the alarm bells must ring as to the relevance of the strategic direction. For finance to truly master strategy, it must embrace uncertainty.
Even though data is a forecast of the future, we tend to treat its veracity with some respect.
The risk management framework
Before starting, it is important to be very clear about the generic competitive position that underlies the strategy, i.e. is the strategy competitive on costs, does it offer a niche position? in an existing market or diversification into a new market. The results of the risk framework will reveal whether the risk responses fit a pattern consistent with one of these generic competitive positions.
Figure 2 illustrates a traditional risk management framework. The starting point is to identify a small number of critical elements that fuel the success or failure of a proposed strategy. These are the risks the company takes when it follows this strategic direction. Figure three recaps some old favorites, SWOT, the value chain, and Porter’s five forces. A fourth area to consider is that of the entry barriers on which the strategy is based. These analysis techniques make it possible to identify both the strategic risks and the strengths of the company.
Figure 3: Tools like SWOT, Value Chain Analysis, and Porter’s Five Forces reveal the risks inherent in a strategy
Once some key risks have been identified, the next step is to assess and assess them in financial terms. We need to familiarize ourselves with how these things can change, for good or bad, how they interact with each other and what the financial consequences are.
In practice, evaluating and evaluating the strategy means developing a financial base case, taking the main risks, and estimating an upward and downward spread over a reasonable timescale. This detailed examination begins with a question such as “over a reasonable period, say three years, how could this risk evolve and what would be the financial implications? “ Concretely, determine realistic scenarios of rise and fall and develop an idea of the sensitivity of the financial result to these risks. At this stage, the objective is to examine in detail the influence of these risks on financial performance and how these can be monitored and mitigated.
Risk response and reporting
A good strategy can be defined as a strategy whereby the strengths of the companies merge with the associated risks, which creates value. Table 1 shows the four generic responses to risks and the strategic risks should align with an accept and hold response. The answers should flow naturally from what the business is already good at. If they don’t, then the strategy is questionable.
|Accept and retain||These risks must adapt perfectly to the strengths of the company. These are the risks that the company takes to create value and over which it has existing expertise to manage.|
|Accept and reduce||These are risks associated with the strategy adopted, but which often arise simply as a result of the conduct of the business. The company must reduce, control and monitor these risks.|
|Accept & transfer||These are usually the risks inherent in doing business. The transfer of these risks can be done through insurance, derivatives or outsourcing.|
|To avoid||These are risks that the company does not derive any value from acceptance and at the same time an appropriate proactive response is not available.|
Table 1: generic responses to risks
Regular reporting is the main strength of finance. The company should identify certain reportable metrics that indicate that its key strategic risks may deviate from expectations. Very often these will be non-financial measures. For example, customer satisfaction is preempted by customer behavioral surveys and analysis, not by declining revenue trends. Creating a reporting process and measuring the actual direction each risk is taking against the baseline scenario is an ongoing process. It acts as an early warning system and enables continuous improvement of the strategic plan.
For finance to truly master strategy, it must embrace uncertainty
A risk framework creates a discipline to determine where the value of the strategy comes from. Analyzing a strategy through a risk framework leads to several advantages. It requires an assessment of strategic risks in financial terms, which in turn exposes the risk to a higher level of scrutiny. Putting numbers on the ups and downs can be uncomfortable territory in the traditional financial sense, but it is an invaluable exercise. The risks identified must align with the strengths of the business and the natural response must be to accept and hold. If not, the strategy is unlikely to be successful. A formal reporting process should be developed to monitor each risk and this regular feedback not only creates an early warning system, but also enables continuous improvements to the strategic plan.
Our discussion of the financial community’s contribution to strategy doesn’t end there and in the next article I’ll describe how value can be measured from traditional accounting output. This embeds value in the financial machine room and from there, the value created or destroyed by the strategy becomes transparent, measurable and a lever for success.
The author, Ben Walters, FCT, ACA is a practicing corporate treasurer with a keen interest in the practical application of corporate finance in the real business environment. He believes that finance can better support strategic analysis and improve the overall value of the company and has developed innovative thinking in this area. He is always eager to be contacted by [email protected]