Financial risks are the uncertainties and potential losses that arise from financial decisions, transactions, and events. They can affect your cash flow, profitability, liquidity, solvency, and reputation. To manage them effectively, you need to identify, measure, monitor, and mitigate them using financial planning and analysis (FP&A).
FP&A is the process of analyzing historical and current financial data, forecasting future performance, and providing insights and recommendations for strategic decision-making. FP&A helps you understand the drivers and trends of your business, evaluate different scenarios and outcomes, and align your financial goals with your operational plans.
FP&A is all about collecting and analyzing financial data, identifying trends and patterns, budgeting and forecasting, and comprehensive reporting that lead management makes informed business decisions. Being in a FP&A role possesses a great responsibility towards strategic decision making and future business performance.
Identifying financial risks is the first step to managing them. FP&A tools and techniques, such as income statements, balance sheets, cash flow statements, budgets, and KPIs, can be used to collect and analyze relevant data. Additionally, external sources like market reports and industry benchmarks should be taken into consideration. Through FP&A, you can identify the sources, types, and magnitude of financial risks such as market risk, credit risk, liquidity risk, operational risk, and strategic risk. Market risk involves changes in market prices that can affect revenue or costs; credit risk involves default or non-payment by customers or lenders; liquidity risk involves not having enough cash or liquid assets; operational risk involves losses due to human errors or system failures; and strategic risk involves losses due to changes in customer preferences or competition.
To identify financial risks, FP&A tools and techniques play a crucial and significant role. Using FP&A, I've identified credit risk and liquidity risk in my career paths. Let's go through a few points below. i) Being worked in one of the best financial institutions of the country, I've identified potential default clients analyzing their monthly repayment behavior (credit history) from the temenos system loan database. ii) Working in start-ups, I've identified the liquidity crisis by forecasting future cash flows including both collection and operational expenses from balance sheet and cash flow statement.
The next step to manage financial risks is to measure them. You can use FP&A methods and models to quantify and assess the impact and probability of financial risks, such as sensitivity analysis, which tests how sensitive your financial results are to changes in one or more variables; scenario analysis, which tests how your financial results change under different assumptions or conditions; Monte Carlo simulation, which generates random values for multiple variables and simulates thousands of possible outcomes; and Value at Risk (VaR), which estimates the maximum potential loss that you can incur within a given time period and confidence level.
The third step to manage financial risks is to monitor them. Utilizing FP&A reports and dashboards can help track and communicate the status and trends of your financial risks. This includes a risk register, which lists and prioritizes the identified financial risks, their causes, effects, owners, and mitigation actions. Additionally, you can use a risk matrix, which plots the identified financial risks on a grid based on their impact and likelihood. Lastly, a risk dashboard can display key financial risk indicators, such as VaR, exposure, volatility, or coverage, and compare them with targets or thresholds.
FP&A tools and techniques play a pivotal role in monitoring financial risks. Using FP&A, I've identified, assessed, and monitored credit risks in my prior career path. Being worked in one of the best financial institutions of the country, I've identified potential default clients analyzing their monthly repayment behavior (credit history) from the temenos system loan database and continued monitoring for 3 to 6 months according to central bank regulatory guidelines (loan classification) whether the repayment schedule got any better or not. Based on my findings, the legal department also issued letters as an initial step towards collecting payments.
The final step to manage financial risks is to mitigate them. Through FP&A insights and recommendations, you can design and implement strategies to reduce, transfer, or avoid financial risks. Hedging, diversification, and contingency planning are all viable strategies to consider. Hedging involves using financial instruments such as futures, options, or swaps to offset market risk. Diversification involves spreading investments, revenue sources, or customer segments across different markets, products, or regions to reduce the concentration of credit risk or strategic risk. Contingency planning involves preparing alternative plans, resources, or arrangements in case of unexpected events or scenarios that cause liquidity risk or operational risk. FP&A is a powerful tool that can help identify and mitigate financial risks while also enhancing financial performance, resilience, and decision-making.