The pandemic article posted nearly two years ago (click here for the full article) started by noting that “external shocks create a multitude of issues that span the short, media and long term for businesses.”.
Financial issues arising from an economic downturn nearly always arise quickly and can manifest painfully for many weeks and months. It is often the firm or business that goes away not the financial issues. The most pressing issues are nearly always revenue, cash flow, and liquidity – the lifeblood of all businesses.
All business owners and managers will be focused on identifying immediate cash flow issues. The severity and urgency will be a function of the type and nature of the business, the industry it is in, and its financial position. Shortly thereafter – or perhaps concurrently – the focus also turns to a range of related and consequential financial risks.
The 52 Risks framework has 16 Financial Risks. They can be found here.
Below are the key financial risks that may arise for many – if not all – businesses in an economic downturn. Even in buoyant economic times, however, these financial risks need to be closely monitored and assessed.
A decline in revenue will occur for a myriad of reasons in an economic downturn. It can be due to demand reducing for the product or service as a result of the knock-on effects of an overall decline in economic activity. It can also be due to a major contract not proceeding or being canceled, or a new business initiative being put on hold or less than successful. It can be due to a major customer going out of business.
Cash Flow Risk will be the risk that there are lower cash flows than originally anticipated over the short, medium- or long-term time horizons. In the context of an economic downturn, it will usually be due to a reduction in revenue or in the trade terms and conditions (debtors or creditors).
Liquidity risk will arise when the business is unable to meet its immediate, short-term payment obligations when due (including repaying maturing borrowings, regular trade creditor, or other expense payments) or otherwise fund its ongoing operations due to operating cash flow shortfalls, acceleration of repayments or other short-term reasons.
Whilst occurring for similar reasons to Cash Flow Risk this is a short-term risk. The usual mitigant for this is cash reserves or undrawn bank lines (such as an overdraft or line of credit).
Financial Leverage Risk
Financial Leverage Risk is usually a risk that gives rise to other financial risks. For example, high or excessive financial leverage going into an economic downturn will potentially give risks to a greater level of cash flow, liquidity, and refinance risk. Any further weakening of the business or organization’s financial position will be exacerbated by high or excessive financial leverage.
Loan Agreement Default Risk
Loan Agreement Default Risk is the risk that a business or organization will breach the terms and conditions of its Loan Agreements and /or other external financing documents (or other like arrangements) due to a change in its business or financial condition. This may be a breach of financial covenants or a failure to meet a scheduled loan repayment.
The type of breach will be dependent upon what the terms and conditions of its financing documents are. The consequences of a Loan Agreement default can include the right of the financier to seek early repayment and/or renegotiate the terms and conditions of the financing arrangement. It will be imperative for organizations to identify these well ahead of time and discuss the position with its financier(s).
For businesses or organizations that have financial liabilities falling due during a period of economic decline the ability to refinance these liabilities may be impacted. During economic downturns, there is often a contraction of available credit – despite the best efforts of policymakers and regulators to attempt to mitigate this.
Organizations must develop plans to address refinance risk well ahead of time. These plans can involve an extension of the term, identifying new sources of finance and/or sources of internal cash flow to meet the maturing financial liabilities.
In times of economic volatility and the implementation of monetary and fiscal policies measures, foreign exchange rates can move dramatically in a short space of time. These changes impact foreign currently denominated revenue and in turn impacts cash flow. Geopolitical issues will often also impact currency markets, often at little notice.
During the Global Financial Crisis, the collapse of many financial institutions also created currency exposures for businesses that had entered into foreign currency hedging arrangements no longer had this protection.
Over the medium to longer-term, permanent shits in currencies impact on the viability of products, business lines, and overseas subsidiaries.
Debtor Default Risk
The risk of loss from a debtor failing to make a payment or payments increases during an economic document. This can be due to many reasons but usually is due to financial distress on the part of the debtor – which in turn will be the result of many factors.
Capital Expenditure Risk
A deterioration in an organization’s financial position – particularly cash flow and liquidity = can see it unable to meet future capital expenditures. These future requirements can be committed or uncommitted (for example future maintenance). It is critical to ensure funding is available for committed expenditures and a detailed understanding is in place for future capital expenses that may not be able to be deferred.
Asset Valuation Risk
The risk of asset write-downs increases in an economic downturn. This can be a result of one or more factors:
- Deterioration in the revenue, cash flow, and earnings
- Changes in assumptions upon which a business valuation has been based such as long-term growth rates, interest rates, or other financial factors (prices or currencies)
- Material changes to an organization’s business model or strategy, such as the closure of a business or loss of key contracts
- A reduction in the market value or saleability of a business
There is a myriad of scenarios that can unfold in an economic downturn. And, as noted above, even in better economic times the above risks need to be closely monitored and assessed. This can involve detailed financial modeling and scenario analysis to understand the financial impact – from profitability, working capital, cash flow and liquidity perspective. This article has more detail on modeling and scenario analysis.