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Cash Flow At Risk: Better Visibility, Better Planning

  • By Riaan Bartlett
  • Published: 9/25/2015

Cash flow at risk (CFaR) can be defined as Cashflowthe extent to which future cash flows may fall short of expectations as a consequence of changes in market variables. CFaR is an excellent corporate risk measure because it will improve the understanding of the risk dynamics of a business and how that risk profile can change due to price changes, entry of new products or geographies, acquisitions, or new projects coming into production. It generally focuses on the market risk that impacts the corporate’s cash flows, ignoring things such as political, operational, environmental and legal risk.

For example, if the forecasted cash flow over the next 12 months is $15 billion, and the forecasted cash flow at the 95th percentile is $10 billion, then the CFaR is $5 billion. This means there is a 95 percent probability that the cash flow over the next 12 months will drop by less than $5 billion, or alternatively a 5 percent probability it will drop by more than $5 billion.

The CFaR process

The steps in the quantification process will typically be as follows:

  • Map the exposures
  • Overlay market-derived statistics
  • Modeling
  • Generate results
  • Determine the impact on the business.

The CFaR process is typically owned by the treasury function as the custodian of financial risks, but the accounting function and the other business units should also provide input. It can be further observed that:

  • The calculation period can range from a quarter up to two years and even five years
  • The market derived statistics should be stress tested to understand the impact of abnormal market conditions
  • Back testing the results can provide valuable insights as to how ‘predictive’ (or not) the model is
  • More weighting can be given to recent data if it is considered more relevant (exponential weighting).

How useful is CFaR?

The value of CFaR does not so much lie in the number itself, but more in the benefit from doing a deep-dive into all the risk factors and cash flow drivers, and the good information this provides to management. In addition:

  • The portfolio dynamics will be much better understood.
  • It is relatively easy to calculate and aggregates the portfolio risk into a single number.
  • It can promote a more robust discussion on risk throughout the whole organization.
  • It can act as a brake against excessive risk taking and can support consistency in decision-making.
  • Unnecessary or costly hedging may be prevented given the existence of natural hedges, i.e., where the portfolio risk level is substantially less than the aggregate risk from individual risk factors.
  • If market risk is managed at the portfolio level, then the business units can fully focus on their operational efficiencies (production, cost and safety).
  • Different scenarios and assumptions can be modeled and stress tested—for example, consider how different CFaR scenarios can impact the FFO (funds from operations) to net debt ratio over a 12 month period. The company can use this information to ensure potential issues (e.g. pressure on credit rating) can be managed proactively. 

When setting CFaR limits, it must be linked to the impact on a ratio, debt capacity, financial flexibility, etc. It will typically be set with reference to a credit rating threshold (e.g., net gearing or FFO to net debt ratio over a 12- or 24-month period). A CFaR to cash flow ratio can be useful to show how the riskiness of the company is changing—recognizing however that if this ratio increases, but it is coupled with higher absolute cash flows, then a higher ratio (higher cash flow volatility) is acceptable.

A good starting point

As a proxy for measuring the downside risk in normal markets, the CFaR methodology has value. It is not intended to be a prediction of ‘how bad things can get’ and it must be seen as the starting point of the company’s risk management process, not the end point.

A competent risk committee that understands this will be well-placed to use it as a decision support tool rather than a decision-making tool. This means that CFaR, as part of the wider risk management framework, will not only assist in protecting the value of the organization but it can also contribute towards creating value.

Riaan Bartlett is a finance and treasury executive based in Pretoria, South Africa.  A longer version of this article will appear in an upcoming edition of AFP Exchange.

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