Risk management is a crucial financial concept involving a systematic framework to identify, assess, mitigate, and monitor potential threats that could prevent an organization from achieving its objectives, with a particular focus on financial risks.
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Risk management is a very important concept
concept
and in fact there's a section of the
syllabus section E that is solely
devoted to risk management and you can
alludes to why because in that
particular section we'll be dealing with
a lot of edging method using derivatives
to manage risk. However, this video will
focus on mostly the theoretical part of
risk management which is you
understanding the risk management
frameworks. How risk can be manage from
identification to assessment to
mitigation and monitoring. Right? So
that's what I'm going to be talking
about today. However, when we get to
section E of the syllabus, we go into
calculation on edging and all of that.
So remember why do we need to do risk
management? Because as finance managers
we always plan and what we have learned
over time is that plan will not be
always the same as actual. So our result
will not exactly be the same thing as
So there is that possibility that it
will not be the same. We know definitely
it can be better which means our actual
can be better or it can be worse. If it
is better then we are fine.
We don't have problem but where we have
problem is when it is worse. When our
plan is actually better than our actual
which is the same thing as when our
actual is worse than our plan. We don't
want that.
So the objective of risk management is
So we want to minimize bad surprises as
Yeah.
So before I go into
the risk management details few concepts
that you need to understand which I see
student getting confused about and the
first one is exposure.
You need to know what is exposure and
exposure is simply the basis of your
risk. That is what is at stake. Yeah.
What what are your concerns? Yeah.
Yeah.
What is the basis of you having such
fear of actual not the same as your
plan? What are you afraid of? So that is
your exposure. So we're talking about
our concern.
Why are we even talking about risk? Why
that will give us that kind of concern.
That's exposure. There's also a concept
And volatility is how quickly or how
often your exposure can change. Yeah. So
So take for instance if you take a loan
your exposure is interest rate because
if you have a borrowing you don't want
interest rate to go up. So you have an
exposure interest rates going up is a
problem for you. The volatility is about
how quickly that interest rate can
change. So your volatility remember is
about things changing so fast. Yeah,
that's volatility.
Very important. And also you need to
understand what we mean by severity.
And severity is just the value of a
What can you lose? What is
the amount of loss you will suffer?
Yeah, that is your severity. How bad can
it be? Yeah, how bad can you loss? Okay,
that's your severity.
Then we have probability.
Yeah, probability is looking at the
likelihood that the risk will
crystallize. So this is about likelihood of
of risk
risk crystallizing
Yeah. Or you call it occurrence
likelihood of occurrence.
Yeah. So that's probability
very important. So now what is risk? I
always tell you risk is just anything
that can stop a company from achieving
its objective. That is the meaning of
risk. What that can stop you from
achieving your objective is the risk
we're talking about. And quickly I will
that you need to be conversant with. The
most important one which will focus on
in this paper is majorly the financial risk.
risk.
Yeah. Though there are other types of
risk which I'm going to quickly touch on
but please take note these our focus for
this paper. And when we get to edging in
section E these are the types of risk
we'll be focusing on edging. And when
you're talking of financial risk, there
are three types of risks you are looking
at. You're looking at the credit risk,
and you're looking at market risk.
And quickly, credit risk is default
risk. So, which usually come
as a result of the asset that you have
take. For instance, account receivable.
When you have account receivable, you
have a credit risk. And the risk is that
your customers will default on their payment.
payment.
So which means you might not be able to
recover the value from your asset. So
when you have an asset, you are exposed
to credit risk. And liquidity risk is a
risk that you might not have enough
money to pay or to settle your
obligation. So usually when you have a
liability, you are exposed to liquidity risk.
risk.
Because with this one you might be
subject to sovereignty if you're not
able to pay your obligation.
So this is about you being able to match
your assets to your liability such that
you have enough cash to settle your
obligations as def. And the third one
for financial risk is the market risk.
And remember market risk can even still
be subdivided into price risk, the FX
risk and the interest rate risk.
You touch this in FM, right? So the
likelihood that change in price or
change in FX rate or change interest
rate might lead to a loss of money is
your market risk. So the possibility of
having a financial loss. So in all of
these three risk
you are afraid of having a financial
loss because of changes that could
happen in price in FX or interest rate
or the fact that you don't have enough
liquid assets to pay your liability or
the people that are owing you are unable
to pay what they are owing you and you
might lose some money there. So that's
financial risk which we'll be focusing
on. But there are other types of risk
that you need to at least understand.
And the next one I'm touching on is the
operating risk.
Yeah. And from the word operating risk,
I'm sure you can relate with it. Yeah.
Usually this is associated with the
nature of business. So because you're
operating a particular area. Yeah.
Almost like a business risk. Yeah. So
nature of your
business. Yeah. Can also call it your
Yeah. So my
strategy might fail
or you might even lose cop staff. Maybe
turnover is high or people that are
quite experienced in your business. They
might leave you and might affect your
business or your operations. You might
not be able to operate properly. So
these are the kind of risk that you will
find in a company. Yeah.
So very important to note this. Yeah.
However, like I said, our focus is on
financial risk. Yeah. So now let's go
into risk management proper.
Risk management. So anytime you hear
risk management, please four things must
come to your mind. Four things.
The first one is the fact that you need
to identify the risk. So first of all is
identification and this concept is so
important because it is the same
all over the sectors all over the
curriculums any paper you are doing any
exams you are writing even if not ACC if
it's CFA if it's CPA whatever risk
management is risk management so that's
why it's good to just understand it now
and understand it once and for all so
the first step is to identify the risk
once you've identified the risk is we
listed them out. Then the next thing is
to do an assessment of the risk.
And why is it important to do an
assessment? Because if you don't do an
assessment, you don't know how to
mitigate your risk. Your assessment is
trying to help you determine how
important the risk are. Because you've
probably identified 20 risk, you should
be able to prioritize them. Which ones
are really major risk and which ones are
not really something you should be
bothering about. So your assessment will
help you to ensure that your investment
in mitigation is just enough and
commenurate to the amount of risk that
you are talking about. So you are not
trying to get a gun to kill an insect.
Okay. So and what are you doing when
you're doing assessment? What you are
trying to do is you are checking the
likelihood that the risk will actually crystallize.
crystallize.
talking about the probability and you're
also checking if it crystallizes what is
the severity.
Remember we've touched on this concept.
So how much impact? This is about
impact. Severity is about impact.
Yeah. How much impact?
Yeah, that's what we're talking about here.
here.
How much suffering will you feel? Yeah.
If the risk actually crystallizes that
is what the assessment is trying to
determine because once you know that
then you can now mitigate and that is
the third stage mitigation and that is
talking about what should be your
and once you've mitigated it does not
end there because risk is very dangerous
so you have to monitor it
because a risk that is very minor and
inconsequential now in about 2 months,
one day, 1 year can change and become
something quite quite important for you
that can even run your company down. Right?
Right?
So these are the four things that you
must always think about anytime you hear
anything about risk management. This is
all risk management is all about. Yeah.
But quickly in terms of mitigation and
your responses, it's good to know what
are your options of responses that you
need to adopt for the assessment that
you have done. And I will draw
a matrix for you that should help you.
And like I said, it's the same in all
curriculum. Whatever you find in risk
management is the same. Right? So I'm
going to put severity
on yaxis
and let's put likelihood of occurrence
on x-axis.
So I'm going to divide this into four quadrants.
So which means likelihood is low here
and um likelihood is high here. So I'll
include high severity here as well and
here we have low severity.
So this particular condrant when the severity
severity
is low which means even if it
crystallizes there's no impact and the
possibility of it even crystallizing is
very low in this case you don't have to
stress yourself. So don't do anything.
So here is no action
and your response
is nothing. You are doing nothing. So in
that case you are saying you are
accepting the risk. No problem. You are
happy with it. Yeah
you are accepting the risk. However
if the likelihood is low but if it
happens the severity is super high
talking about this area. So in that case
you have to have a contingency plan.
So this one you have to do something.
You have to do a contingency plan or you
say okay you are transferring the risk.
That is why you would do insurance. That
is a popular example of how you can
transfer risk by having insurance. You
know the likelihood of having an
accident or fire burning a building is
very rare because of the controls you
have in place and everything. However,
if it happens, the whole building might
be burnt down. You might lose your whole
car. So, because of that, you have an insurance.
insurance.
Here is a possibility of
having a high likelihood. So which means
it will always or mostly going to happen
if you don't do anything though the
severity is very minimal is low but you
know little because it happens
frequently even with little severity if
it happens so many times and you
accumulate little severity it might
become high severity. So too many
occurrence 1 + 1 in 1 million places is
already 1 million. So in this case you
cannot also keep quiet. So you have to
do something. Yeah. And that is why you
adopt a reduction approach. So here you
have to reduce the likelihood of occurrence.
occurrence.
So and what you can do is to put
controls in place to do that. The most
critical portion which is quite
dangerous is when the likelihood is very
high and severity is very high. This one
is in emergency. So you need to act
immediately and what you have to do is
to leave that business. You can't do it.
So you have to avoid you have to stay away.
away.
Yeah. You have to stay away from that
because the danger is high and the
likelihood of occurrences also very high.
high.
Yeah. So there's another model that you
call for T's that you can also use for
risk management which is similar to
transfer avoid accept reduce. So like
for accept you say you want to tolerate
that is another word if you're using 40s
so same thing tolerate you can say
tolerate and this is already transfer
yeah so it's still already so you can transfer
transfer
and you can as well terminate if you
don't want it if it is
high likelihood high severity then
definitely you have to terminate that
risk stay away from
Don't get close. Terminate. And
And
for the high likelihood and low
severity, you will say you have to treat
it so that you reduce the likelihood you
treat it.
Yeah. This one you transfer. Yeah.
Yeah.
Okay. So that is the concept about uh
you responding to your risk. Yeah. And
monitoring is the last part which is
very important. After your response, you
don't stay there. Like I said, a risk
that used to be in this quadrant can
jump all the way to this condrant. After
some anything can happen even from here,
a risk can jump to this part. So you
need to be careful. And the one that was
there can also jump back which means you
need to save money and don't bother
yourself. So they can move across this
quadrant and as they moving you are
changing your strategy, you are changing
your response. Very important and that's
the essence of monitoring. Yeah. But you
know in the financial space you can use
financial ratios for monitoring your risk.
risk. Yeah.
Yeah.
Yeah. the edging method. We'll deal with
it in section E. But here you need to
learn how to use financial ratios to
monitor your risk. Yeah. Because if your
profitability is coming down or your
your debt profile is going high or you
are getting into liquidity problem, how
do you know? And that's why you can use
ratios to quickly deal with that. So
remember in the financial world which is
where we are and that is what we'll be
focusing on. I will talk about key
ratios. Yeah the first one is
profitability ratios.
You can also re revise your ratios. very
important and the major one that you
will use to monitor your profitability
or the use of your asset is ROI because
this is a ratio that check how efficient
you actually utilizing the funds that
have been made available by the fund
providers talking about debt providers
and equity providers
right so you know that if this ratio is
bad then you should be checking yourself
to know what is really going on Because
to calculate ROSI, you remember it's
profit before interest on tax. Then you
divide it by the capital employed
and capital employed is your
equity and debt. Right? Very important.
And what are you saying here? You're
saying that you want to know how the
asset has been utilized. And this is
divided into two parts. looking at how
the asset has generate revenue
and that is talking about asset turnover
calculated as revenue divided by asset
and that revenue that you have generated
is not the profit itself. The profit is
the margin on the revenue. So margin is
very important and that is you're
upon the revenue
that the asset has provided and that is
ratio of Rosi is also calculated by
multiplying your asset turnover
by the marginal Prof operating margin.
This is operating margin that we are
talking about here. Right? So you see
If you multiply those together talking
about revenue
over asset
multiply by PBIT
over revenue. So now if you cancel this
one out what you have back is your PBIT
over asset. Now remember your accounting
equation your asset is equals to
liability plus equity. So that is why
this is still the same thing as your PBIT
PBIT
over capital employed of asset which is
the same thing as liability plus equity.
So that is
an an analysis that you have to really
be comfortable with. So
So
that is how to monitor your
profitability. But you also need to be
able to monitor your liquidity risk.
See, I'm focusing on financial risk
monitoring now. So to monitor your
liquidity risk, you already know the
ratios. You're going to use two ratios.
and you're going to use your quick ratios.
ratios.
Remember these are very simple ratios.
Current ratios is your current asset
divide by current liability. Ideally,
you expect it to be two
and um at least around that two or if
it's anything or significantly less than
two, you know there's a problem. and
quick ratio you need to adjust for
inventory from your current asset but
still going to divide it by current
liability and naturally ideally you
expect to be one and if it's
significantly less than one you need to
be worried and need to act fast and do
something to your liquidity because you
might be running into big trouble
likewise gearing is another way to
monitor your financial risk and remember
gearing is debt equity ratio that is
debt divided by equity
And if you're talking of total debt,
total gear, you're talking of debt
divided by debt
plus equity.
Both formulas are acceptable. Yeah,
usually you want something around 50%,
but what you should also know is that
it depends on a lot of things. Remember guarant
guarant
you're talking about risk. Yeah. As a
How a company is funded. Please take
this very importantly.
Yeah. You see a lot of equities, a lot
of debt. Yeah. You want about 50% but
the level of debt depends on so many
things. So you can't say for every
company it has to be
in a certain percentage because you're
talking of
industry is important. Yeah.
Yeah.
If you're looking at um manufacturing
industry, there's a likelihood that they
may have quite huge number of debt to
acquire big machines to buy a lot of
things. But if you're just in a service
industry, you might not have so much
amount of debt. Also, the size of the
company is very important.
Big companies tend to have high level of
debt because they are even able to get
more debt. Yeah. And probably expanding
and all of that. So size of company very
important. And also the prevailing
economy Yeah. is quite important. Yeah.
If there is recession, you probably
won't see a lot of debt because people
will not be able to to afford debt.
Likewise, the bank might not even be
willing to give anybody debt because
nobody is trusting anybody during
recession. You want to keep what you
have at this point because you know
people might struggle to pay back. So
all of this will determine the level of
debt and as such the gearing that will
be appropriate for any particular
company. So that's it about risk
management. Remember it's about four
things. Risk identification, risk
assessment, mitigation of the risk, and
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