Role of a Treasurer in Identification of Risk Finance Essay

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Companies have always been facing many risks that gained complexity with the passage of time. Such risks became impossible to be managed by a single person and required the assistance of experts to deal with them. The trend of adopting the globalization policy and exploiting the advantages offered by the international markets has caused many risks to enter the operations of the multinational companies. The management of this risk has been necessary as they cast their impacts directly on the profitability of a company. Therefore the treasurers gained importance in the industry and companies started to rely on their knowledge and experience to save them from arising risks and threats. This report will focus on the important roles that a treasurer of a multinational plays in the entire risk management process of a company related to its financial activities and will highlight the important role that a treasury department plays in ensuring the profitability of a business.

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Table of Contents

Introduction

With the pace of time, the operational environment for the corporate world has been changing and is yet in a similar phase. Businesses started to move globally to exploit larger markets and better infrastructure. The concept of ‘Economies of Scale’ was also a leading factor that led many giant corporations to adopt a globalization strategy. The exposure of the company’s operations to many unfamiliar factors of the new environment brought many risks associated with it. It was not only the globalization move that exposed companies to the increasing risks, but the intense domestic and international competition, changing legislative requirements and stringent operative environment also made big corporations to focus intensively on the management of the different risks resulted from such changing business atmosphere. Therefore, a concept known as Enterprise Resource Planning evolved to address such anomalies for the businesses. The prime purpose of an ERP process is to control the risks that are faced or are likely to be faced by a company, in order to enable it operate without any interruption. (Culp 2001-a). An important part of every organization’s operations is the financial department. This department is managed by people called treasurers who have the responsibility to manage all the financial activities of a company which can include the dealing of bonds and certificates, foreign exchange trading, dealing in derivatives and options, and most importantly, the management of financial risks of the company. As a treasurer has a deep understanding and experience of dealing with the financial commodities and all the financial processes, the company relies heavily on this expertise to manage any financial risks faced by it. (Culp 2001-b)

Types of Financial Risks

The basic responsibility of the treasury department in an organization is to manage the financial activities of it, and ensure that the company is financially healthy. The approach to financial risk management changed altogether with the increasing globalization strategy. The companies with international existence not only opened doors to new markets and opportunities, but also let the risks to step in as well. Multinational companies started to face many hurdles and new challenges. The role of treasury was no more to deal with the internal and domestic risks of liquidity, credit, and market, but their responsibilities extended further to protect the company from the challenges and consequences of dealing with foreign exchange risk and risks exposed by new markets. The companies were no more dealing with their domestic banks and lending institutions only, as they considered it necessary to use the local funding opportunities of the new regions since they were cost friendly as well as efficient. This also exposed the companies to the risks of changing interest rates on their international borrowings. In order to achieve this security, it becomes necessary to consider the risks that are exposed to the organization’s financial activities and how those risks can be minimized. The financial risk is divided into several categories as follows; Credit risk Foreign exchange risk Market risk Interest rate risk Liquidity risk (Saunders 2008).

Risk management Process adopted by Treasurer

Treasurer, who bears the responsibility to manage the financial risks associated with a company, has to adopt a systematical approach in this concern. This approach starts with the process of identifying the context of risk, identification of risks, which is followed by the measurement of identified risks and finally the determination and implementation of suitable steps to mitigate them. This is an approach appreciated by the standard, ISO 31000 “Risk management — Principles and guidelines on implementation,” (ISO/DIS 31000 2008)

Establishing the Context

This is the first part of a risk management process, where a company has to identify in collaboration with the relevant departments, about the context in which a risk needs to be identified. This is important because, it leads the entire risk management process. If a risk is relevant, only then it needs to be analyzed further. The context of risk identifies the interest of the stakeholders and the operational scope of the company, and devises a framework on whose basis a risk will be assessed and measured. Therefore, the context of risk relates the objectives of the stakeholders to the risk management process and ensures that the company is not wasting time and resources on the management of irrelevant and immaterial risks, by creating a level of materiality. (Allen 2003-a)

Identification of Risk

Before a treasurer decides to act and save a company from the risks, it is very essential to identify it first. As the intense business environment offers several types of risks and challenges that have to be faced by the company, every area of operation has to deal with the risks that fall within the scope of their expertise. Therefore, the identification of the risks is necessary at the corporate level while parallel risk identification is certain to take place at the departmental levels. A treasurer once identified a risk, needs to categorize it into one of the above mentioned types. Depending upon the type of the risk identified, the further actions are decided. (Allen 2003-b)

Analysis of the Risk

The treasurer once identified the risks, needs to analyze it to identify the potential impact of the identified risks and the likelihood of their occurrence. In practice, the treasurer has to make best possible estimated to identify the likely impacts of the events and transactions which have not yet occurred. This is a critical process which decides the future course of actions to protect the company from the potential risks identified. If an identified risk is causing a potential impact on the company, i.e. the financial consequences are material, and the risk is more likely to materialize than not, then the treasure has to take further steps to mitigate the risk. The materiality of the risk is identified by comparing it to the context of risk identified at the initial phase of the risk management process. (Allen 2003-c) Source: https://beta.irri.org/news/bulletin/2005.32/

Risk Exposures

The researches in the field of financial risks management identified that the treasury of a multinational company besides dealing with all other types of risks, have to face extensively the risk of changing in foreign currency rates. Foreign Exchange Risk is considered to be one of the most influencing risks in becoming a globalized business. This is a risk that the foreign currency rates will move in an unfavorable manner for the company. As a multinational company deals with the local currencies of the regions, this risk arises when the receipts from such regions has to be brought into the home country. An adverse movement of foreign currency rate often leads to huge losses, when converting it into home currency. This risk is more significant if a company’s investment decreases its value due to the changing foreign exchange rates. (Daniels 2007-a) Foreign Exchange Risk is associated with three exposures namely; Transaction exposure, economic exposure and translation exposure. Transaction exposure is connected with international trading and is defined as a threat that the exchange rates will change after a company has entered into an obligation to pay back. This change in exchange rates due to the time factor, causes huge losses to multinational companies, if they are not managed properly. (Daniels 2007-b) Economic exposure is faced by the multinational firms when they have to deal with the changing exchange rates affecting their returns from foreign investment projects. This risk is associated with the cash flows of internationally trading businesses. (Daniels 2007-c) Translation exposure arises when the company is operating internationally and has prepared financial statements of its subsidiaries in those regions in their domestic currency. Companies have to translate the financial statement into presentation currency, which is often different to the functional currency in which a company operates its day to day transaction. Therefore, the translation of functional currency, into presentation currency exposes to translation risk. (Daniels 2007-d)

Mitigation of Risk

A treasurer, once identified and analyzed the risks, has the responsibility to take steps to ensure that the identified risks are prohibited from affecting the operations and well being of the company. As the treasurer is responsible to mitigate the risks associated with the financial operations of the company, the efficiency of risk management in this area has direct consequences over the profitability and long terms sustaining of the firm. In order to mitigate the risks, there are four choices that a treasurer can choose from, to ensure the risk is addressed.. The four basic approaches to risk elimination are as follows; Avoiding the risk Reducing the risk Sharing the risk Accepting of the risk The choice of option depends on the individual circumstances and the type of risk identified. (Webb 2003-a)

Avoiding the risk

This is the most pessimistic approach to mitigate the risk. A treasurer decides to eliminate the entire project that leads to the risk being arising. A very common example can be of an investment project which leads to high Net Present Value, but the risk of financial liquidity associated with it is high. In order to avoid the risk altogether, the treasurer decides to avoid the implementation of the project. Although the avoidance of risk leads to elimination of it but it also causes many potential projects being discontinued due to the same reason. (Webb 2003-b)

Reducing the risk

Risk inclined management is likely to adopt this method of dealing with the risks, instead of avoiding it altogether. This method involves taking steps to reduce the likelihood or impact of the risks by using different approaches. The possible methods of risk reduction can include the use of range of investment portfolios in order to ensure that if one investment fails and brings loss, the others perform well and prevail over it. Another method of risk reduction is to creating a mix of conservative investment projects and aggressive investments, so that a balance is maintained and the risk becomes neutral. Multinational companies also use hedging to reduce their foreign currency risks. In this process, the companies secure their future transactions by paying a minimal premium. Treasures deal with the hedging as a part of their routine and use this risk reduction technique extensively to deal with the changing rates of international currencies. Hedging can be categorized into following types; Forward Contracts is a process in which the two dealing parties agree to trade in a scarified future date at a predetermined rate of currency. This saves the companies from the adverse impacts of the changing currency, and is used widely by the treasurers in reducing the foreign exchange risk of their companies. Swap is another derivate used highly by the treasury department of a company to manage and reduce the foreign currency risk. It is defined as; “the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps.” (Investopedia 2011) Option is another instrument that helps the treasurer to reduce the financial risks. “An option is a contractA that givesA the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.” (Investopedia 2011). The cost associated with the options is the payment of premium but the advantage of it is to either exercise the right or reject it, depending on the future circumstances. (Webb 2003-c)

Sharing the Risk

This is an approach where the treasurer will try to share the risks with other parties instead of rejecting to accept it at all. This is another approach adapted by risk taking management who realizes that big profits come with huge risks, but measures should be taken to reduce such risks, so as to benefit from the gains. The common types of risk sharing techniques include outsourcing and insurance. (Webb 2003-d)

Accepting the risk

A treasurer will only accept a risk if the avoidance of it is not favorable to the best interest of the company. An example scenario can be a case where the company will incur more to avoid the risk than the original cost of the risk itself. Under such circumstance, and according to the cost vs. benefit analysis, the company will accept the risk. A treasurer will also accept a risk when the project is necessary to be implemented and the prime aim of the company is not to obtain financial advantage. An example can be the launch of a temporary product line so as to cherish the customers and retain their loyalty. (Webb 2003-d)

Impact on Profits

A poor risk management always lead to huge losses and therefore the overall profitability of the companies suffer. The investment projects involve huge outflow of cash which have to compensate with the inflow of cash generated from it. However if the risks associated with the investment are not managed, the investment is likely to cause huge burden of loss on the company’s profitability and the impacts of giant investment projects gone bad last for many years. Similarly the poor management of foreign currency dealings will lead to great losses. The unmanaged investment portfolio and improper mix of sources of fianc© can lead to severe consequences which can include the company getting defaulted. The long term survival of the companies depend on profitability and to ensure that the company remains profitable, it is necessary that the treasury department plays it vital role in managing the risks that can lead the company to face the situation of losses and failure. (Grant 2004).

Conclusion

Treasury department has gained a huge importance in the present scenario of business and their presence is necessary to ensure that the companies are efficient in dealing with the risks associate with the financial activities. Multinational companies who have to trade in several regions which each has its own currency and environment, need to use the expertise of a treasurer to ensure that their international dealings are managed effectively and the risk of foreign exchange trading is minimized. In such an intense business atmosphere, the trades need to be efficient at all levels and therefore they cannot bear the losses that unmanaged risks can cause to their profits. The treasury department is the place where the owners of a company look for when the question of financial risk management arises. The multinational companies cannot survive the complexity of the foreign currency implications on the profitability of the companies and therefore the role of treasurer becomes ever important. They not only have to identify the risks but also mitigate them to ensure that the survival of the company is possible and the profitability of it is not compromised.

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Role Of A Treasurer In Identification Of Risk Finance Essay. (2017, Jun 26). Retrieved December 7, 2022 , from
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