5 Reasons Why Finance Teams Should Care About Risk Management
Risk is widely understood as one of the key components of finance. While modern financial theory states that higher risk is associated with higher potential return, reckless assumption of risk without properly aligning internal operations could also create a bevy of issues for your organization.
In order to avoid such catastrophic failure and continue stable operations long into the future, it is vital that companies accurately monitor and control for a number of possible finance risks. While risk is uncertain by nature, responsible organizations should at least prepare themselves for difficulties that other companies have commonly faced in the past.
Here is a list of five of the most significant risks that finance teams should be prepared to handle through the implementation of risk management strategies.
Bankruptcy occurs when an organization does not have the adequate cash flow to continue operations. Stories like the downfall of Enron in 2001 or the Lehman collapse of 2008 may dominate news headlines, but bankruptcy is far more common than you might expect.
In fact, there were over 20,000 bankruptcies in the fourth quarter of 2018 alone. If that sounds high, consider the fact that the number of bankruptcies has actually fallen by nearly three quarters from a high of 82,446 in the fourth quarter of 1987, following the stock market crash known as Black Monday.
2. Equity Market Downturn
It is clear by examining the largest bankruptcies of all time that many, barring cases of fraud or malfeasance, tend to cluster around major financial crises, such as that of 2008. In such cases, the market cannot provide a floundering organization with access to the capital necessary to maintain successful business operations.
The bankruptcy of real estate investment trust Thornburg Mortgage provides a valuable case study of how such a situation may unfold. Following the collapse in housing prices triggered by the subprime lending crises, Thornburg Mortgage faced mounting losses that triggered margin calls. Due to the significant downturn in the equity market at that time, the company was unable to raise the capital necessary to meet its margin calls and was forced to file for bankruptcy.
3. Schedule and Resource Contingency
Schedule contingency is important when planning for projects on fixed schedules. If tasks are defined and allocated in precisely the amount of time necessary to complete a project by a given deadline, it will be difficult to adjust for obstacles or delays as they arise, not to mention the fact that it is virtually impossible to know exactly how long a specific component of a longer-term project will take anyway.
Resource contingency involves setting aside extra money in an operational budget as a buffer to cover unexpected costs that may arise. Contingency rates of 5-10% of an overall budget are common, but it is up to each company to decide this for themselves. In any case, facing unfinished tasks with a fully drained budget is a problem for any organization, big or small.
A company that does not effectively implement contingencies may suffer from a lack of available options when problems do occur down the line. To avoid this, it pays to consider any potential complications and necessary project buffers well in advance.
4. Project Overspend
Along the same lines as resource contingency, companies must ensure that they employ their funding effectively to see a project through to completion. Blowing past budget constraints can delay a project at best, as is usually the case with large construction projects, or cause outright cancellation at worst, as happens frequently in the video game industry.
While the most over-budget projects of all time are all large public works projects, going over budget can also severely impact the ongoing operations of a small or medium-sized business. For example, local construction companies or other service providers must stay within budget to satisfy developers and earn continued contracts in the future. Failure to stay within budget can negatively impact an organization’s reputation and lead to missed opportunities in the future.
5. Financial Reconciliation
During the accounting process of reconciliation, companies make sure that two sets of accounts match. This ensures that the books are balanced, so to speak, within a given period of time. Companies that do not institute an effective system for recording and tracking transactions may find that they are unable to effectively monitor, manage, or settle their business transactions when necessary.
Reconciliation is an essential function of any finance team, as regular balancing helps to detect any unusual transactions that may result from errors or outright fraud. Publicly listed companies also benefit substantially from detailed financial reconciliation, as small and unnoticed errors and discrepancies could add up to significant inaccuracies when reporting quarterly financial information.
Risk Management Solutions for Finance Teams
While this list contains only five of the top risks facing finance teams, there are an unlimited number of ways in which uncertainty can manifest itself and sideline the business ambitions of the unprepared. If nothing else, the risks detailed above demonstrate why instituting risk management for finance teams in your own company is so necessary.