Cash Flow at Risk - Earnings at Risk - Integrated Corporate Risk Management
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Cash Flow at risk is an integrated Corporate Risk Management solution. The Cash Flow at Risk approach answers the question of how large the deviation between actual Cash Flow and the planned value (or that used in the budget) is due to changes in the underlying risk factors. The Earnings at Risk approach is a similar view of the problem, based on book depreciation. Here the focus is not placed on financial accounting in-flows and out-flows (Cash Flow), but instead on profits and losses relevant to the many clauses of trade law.
Cash Flow at Risk - Earnings at Risk - Value at Risk
Companies engaged in international business face many financial risks. These risks are mainly focused around currency exchange, cost of raw materials, interest rates, and the stock market.
Investors, customers, suppliers and legislation are all pressing for transparent reporting and an objective display of the operational and financial risks. The main problem lies in deciding how these financial risks affect the profitability of a company.
Compared to pure financial companies, the industry and trading houses are forced to face additional uncertainties. Often operational Cash Flows depend on market risks and raw material price risks. For example, unfavourable currency exchange development can lead to a reduction in export volume. Also, by holding sale prices constant after an increase in price of raw material will lead to a reduction in profit.
An unfavourable development in interest rates can lead to the net debt capital service becoming more difficult, and "collaborating" risk factors can destroy the liquidity of the company.
But how do changes in the raw material price and currency exchange rates influence operational Cash Flow, profit or turnover? With what probability will operative Cash Flows cover the financial needs of the company (thereby safeguarding liquidity)?
To answer such questions, one needs a custom tailored method targeted to each specific company and their individual risk position.
The Cash Flow at Risk approach answers the question of how large the deviation between actual Cash Flow and the planned value (or that used in the budget) is due to changes in the underlying risk factors. This probability is quantified by a probability e.g. 95% in the next 12 months.
The Earnings at Risk approach is a similar view of the problem, based on book depreciation. Here the focus is not placed on financial accounting in-flows and out-flows (Cash Flow), but instead on profits and losses relevant to the many clauses of trade law. So, for example, one could calculate how large the deviation between the "probable" profit and a planned yearly profit is with a probability of 95%.
The Value at Risk approach is used to quantify the risks that originate from assets like share portfolios, bond portfolios, or raw material resources.
Since corrective actions to reduce the risk of the operational business take time to implement and become effective, the prognosis horizon often lies beyond 12 months.
Analogous to a large tanker moving at full speed, companies need to detect their risks as early as possible in order to be able to take preventative action in time, otherwise a collision is inevitable.
The following figure shows a schematic view of the Cash-Flow at Risk measurement. With the help of statistical prognosis models, we estimate confidence intervals for the period of the next 12 months for all relevant risk factors.
The statistical prognosis methods simulate thousands of scenarios of the potential development for the relevant risk factors. For every risk factor, a two sided confidence interval is calculated. For every scenario (i.e. change in one risk factor), we analyze the consequences for the operative Cash Flows. In this manner, a frequency distribution of the future Cash Flows can be assembled.
Such distributions allow a company, for example, to judge with what probability an expected Cash Flow can be realised, how large the deviation from this target value could be with a given probability, and with what probability the liquidity of the company is in danger.
The implementation of Cash Flow- or Earnings at Risk models requires economical as well as statisti- cal Know-How. The ccfb Prof. Dr. Wiedemann Consulting offers this service in conjunction with Approximity. While ccfb has based their main focus on the economic components of modern Risk Management Systems, Approximity brings the corresponding Know-How with prognosis models for the market price risk factors.
We look forward to sending you additional information material or to schedule a personal counselling interview with you.