Edition 52, Finance

Risk Mitigation Through Efficient Management of the Balance Sheet

By: Juan Sadurní

All companies face the daily challenge of managing uncertainty to create sustainable value in an environment that is increasingly difficult to predict.

Changes in the structure of markets, consumer preferences and the regulatory framework are combined with complex operations, which are therefore volatile.

Volatility is an obstacle to the healthy growth of companies. Organizations of all sizes and in all industries have seen how changing market conditions repeatedly affect their financial position, slow down their expansion plans and threaten the stability of their operations.

The financial crisis that began in 2008 revealed to the world community the importance of the relationship between market volatility and the expected revenues of a company. Movements in interest rates, exchange rates and other critical variables caused heavy losses and made investments that seemed infallible abruptly lose value, including with catastrophic consequences, such as government intervention, hostile takeovers and even bankruptcy.

In an international study by Accenture, it was revealed that the three main risks that companies face come from information technology systems (39%), the factors that define the cost and price of products (39%) and the movement of the global economy (37%). There are success stories in the resilience of companies that have actually generated returns of more than 100% of their risk management investment in the supply chain, but Accenture qualifies only 7% of the companies as leaders in practice.

The leaders in risk management do three things that distinguish them from other companies:

  1. They give priority to risk management. 61% of the leaders, unlike 37% of other companies, take risk management as a strategic imperative and recognize the importance of the skills that help them gain greater visibility and predictability through their supply chains.
  2. They centralize responsibility for risk management. 43% of the leaders, compared with 32% of others, established a central risk management office led by a senior management executive or a vice president who oversees all of its activities.
  3. They invest strongly in risk management with a focus on visibility and analysis of the supply chain from one end to another. The leaders were almost three times more likely to indicate that they had plans to improve their investment in risk management by 20% or more over the next two years. In addition, nearly 70% of the leaders said that their investments would generate a return of at least 100% over the next two years, compared with 4% of the others.

The best management practices require that senior management determine how many risks the company is willing to take to achieve its goals. That is, it has to define its “appetite for risks.”

Associated with the foregoing is the urgent need for actions, processes, tools and reports to ensure that the organization is able to optimize the relationship between risk and returns and act according to a logic of prevention and mitigation of volatility, which only occurs when the risks and their causes are identified and assessed appropriately. One of the best ways to reduce volatility and counteract the negative effects is to optimize the balance sheet. Efficient management of the balance sheet allows the organization to prepare to grow and strengthen its financial position.

The main tool that we use at Accenture to optimize the balance sheet is the “equation of liquidity,” a conceptual framework that identifies the critical elements of managing a company that facilitate the alignment of investment decisions and funding with the minimum liquidity requirements to ensure operation and subsistence.

Increasing EBITDA
Identifying areas for improvement in EBITDA involves a thorough analysis of the financial performance, considering an increase in operating income and a decline in the real cost of financing for each product or line of interest.
It is essential to incorporate indicators that, in addition to the classical view of profitability, make adjustments based on the inherent risk of each transaction. Many institutions already replaced the traditional return on equity (ROE) for the most complete risk-adjusted return on capital (RAROC). These adjustments involve a different way of thinking and operating that reaches methodologies, processes and systems.

Optimize CAPEX
An efficient management of CAPEX’s main objective is to optimize the dynamic allocation of capital in order to meet the future needs of the equipment according to the company’s investment plans.
With this type of management, the characteristics of each investment (costs, objectives, requirements, risks) are understood in order to promote those that represent the best returns with less risk to improve the IRR, the NPV and the cash flow. In addition, it ensures the timely availability of resources according to the investment needs, avoiding administrative bottlenecks and failed projects due to lack of resources. This is also a way to promote the generation of synergies in the funding of initiatives, the dynamic management of the cash flow and, with this, the value of the company.

Making the Working Capital More Efficient
The dynamics of working capital are such that sometimes companies can enjoy an operational profitability, but with a very limited cash flow, so it is essential to incorporate a realistic analysis of the real needs of capital to operate. The analysis focuses on improving the cash conversion cycle in such a way as to safeguard the continuity and effectiveness of the operation without destroying financial value.
This efficiency of working capital improves the process and policies in order to reduce labor costs (assets and liabilities); optimizes the performance of the inventories (both finished goods and investments) to balance the financial indicators with operational actions; and integrates the management of working capital with other critical aspects of financial planning to avoid independent processes that increase inefficiency and costs.

Centralize Investment Decisions
This is to ensure that all investments and key financial decisions are integrated under a single management. This initiative allows the company to improve its performance by increasing trading volumes (and, therefore, market conditions), thus providing better coverage; separates the interest rate risk of operations, assigning it directly to the Treasury, so that the business units focus on the risk factors that are under their control and in the operation itself, and requires that the institution has a corporate governance in which senior management is actively involved in monitoring the management framework of the investments.

Optimize the Capital Structure
It is desirable that the company has the optimal financial leverage and capital structure for their appetite for risk, type of operation and investment needs. The goal is to find the balance between equity and debt so that the cost of capital is the lowest for the company (optimization of WACC).
Thus, the correct composition of liabilities and capital is formulated to meet the needs of liquidity, minimize the cost of funding and maximize the risk-adjusted return.

Optimization strategies are, among others, the acquisition or emission of coverage and the retention of earnings. The creativity and flexibility of the institutions have an impact on the success of their strategies and the generation of value.

The correct application of the equation of liquidity brings significant benefits. Even the best operation of a company can benefit from optimizing its financial structure and derive an additional value-added to the product generation, recruitment of talent or optimization of costs. A high cost of capital, an unfavorable debt collection cycle, inefficiency in making investment decisions or the lack of liquidity involve greater volatility, which has an impact on the value of the company and its ability to enjoy high growth that is both healthy and sustainable.

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