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Setting Your Risk Appetite Amid High Volatility

  • By Andrew Deichler
  • Published: 1/24/2018

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The following article is excerpted from the AFP FP&A Guide,
underwritten by Workiva, Planning in the Age of Volatility.

Organizations must establish their risk appetite as they plan around volatility. All businesses incur a degree of risk, but how much they want to take on varies heavily. The risk appetite is generally established by the board of directors and communicated by the CEO through the markets in which the company operates, the business and products/services delivered, and the strategy and tactics pursued. FP&A is responsible for translating those down to the business units in digestible pieces.

When a company establishes a risk profile, it determines how aligned it wants to be to the items that drive volatility. “Do you want to participate in 60 percent of the upside and 40 percent of the downside? Protecting against the downside is more important; a 30 percent loss has more impact in the long term than a 30 percent gain because you have to recover from the loss,” said an attendee at the FP&A Roundtable at AFP 2017.

Of course, the amount of downside you’re willing to take on depends on knowing your stakeholders—for public companies, that means the board of directors and shareholders. “Are your shareholders buying your stock because they want dividend producing stock, or are they willing to deal with volatility?” Bryan Lapidus, FP&A, CFO Advisory for Allegiance Advisory Group and a contributing consultant for AFP, asked. “You have to know who your sources of capital are because they’re the owners of the company and they’re going to fire you if you don’t manage according to the risk they are looking for.”

And for those organizations experiencing the downside, do your best to find the opportunity there. You may be able to identify ways to turn it to your advantage. It may be helpful to design a scenario. What would Amazon/Google/Apple do? If you can identify that and apply a new strategy, you might be able to emerge stronger than you were before.

Diversification can also help your organization overcome volatility because it spreads risk around. Another roundtable attendee recommended establishing a footprint in multiple markets, having some redundancy in your supply chain, and operating multiple products and business lines. This might make you less efficient overall, but it may be necessary to manage the risks.

“Optimizing efficiency is often at odds with minimizing volatility,” said Lapidus. “If you’re an airline, you can minimize the impact of buying jet fuel by having a huge storage depot that you stock up yourselves. But that’s a huge cost. Any company with a warehouse has that issue. I can have better fulfilment time by operating a huge warehouse, but now I’ve tied up all my working capital and I’m less efficient.”

It’s a good idea to get a handle on the variables that you have no capacity to forecast. Obviously extreme weather events can’t be predicted, but also market-based variables such as oil prices fall into this category. When planning around volatility, it’s a good idea to pinpoint which of these variables could have a major impact on your organization and factor them in to the best of your ability.

“You have to monitor your risks even before the problems arise,” said another practitioner at the roundtable. “That means monitor your biggest expense drivers and where possible, and de-risk by locking them in (i.e., leases, long-term contracts) so that you can plan without the volatility.”

For more insights on how FP&A can plan for volatility, download AFP’s FP&A Guide here. Also, don’t miss the session, Volatility is the New Normal, at FinNext, March 20-21, 2018 in San Francisco.

Download the 2018 AFP Risk Survey, supported by Marsh & McLennan Companies’ Global Risk Center, here.

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