With all the recent financial mess in the global marketplace, financial risk management has come to the forefront of the global economic environment and thus the financial industry in countries around the globe.

Following loosening of credit controls in the 1990s, world markets enjoyed healthy bottom line growth; growth that proved to be unsustainable when, in 2008, world markets tumbled and economies which leant toward the pure market model became increasingly socialized with governmental bodies buying up distressed assets.  According to the measure for economic recession of two consecutive downward cycles, European markets were classed as in recession in 2008 while US markets were determined to be in recession as of December 2007. Banks and commercial entities have become painfully aware of the negative impact on the bottom line that can be caused by market volatility.

Financial risk is diversely assessed among companies and financial institutions based on that entity’s characteristics – characteristics such as size, credit quality, customer diversity and profit margin, to name a few. A low-margin, poor credit profile manufacturing organization, for example, may be much more predisposed to stabilizing cash flows, as accurate planning and forecasting becomes an integral part of maintaining status as a going-concern and securing credit lines. On the other hand, a large oil & gas exploration and production organization whose profit margins tend to be very large in times of high oil prices and only moderately large in times of low oil prices may be more risk-seeking as higher market volatility often translates into higher profit margins. As with any financial analysis undertaking, it is always important to keep the industry, company, as well as the current and expected financial and economic environment in mind.

PREDICTING THE FUTURE

Financial analysts often use well-esteemed liquid financial market forward price curves as inputs to their analysis to appropriately assess financial risk. Again, it is integral to robust analysis to consider the particular industry before blindly selecting a price curve given that financial market liquidity, and thus accuracy to future pricing, can vary widely.  The energy markets, for example, are often relatively accurate when trading the prompt month (the nearest month in the future that is not the current month), but become less reliable in farther out months and can completely flatten out and become predictably unreliable after a 12-month period. This illiquidity is a product of the difficulty of predicting energy markets in these farther out months, resulting in substantially lower trading activity. This phenomenon is easy to understand as we view crude oil prices which traded at approximately 140 USD per barrel oil prices in mid-2008, when few speculators thought these prices would ever drop down to earlier levels, versus the current price which hovers around 45 USD per barrel. Depending upon your risk aversion, whether you seek cash flow stabilization or speculation opportunities, depends upon whether you view this added volatility (aka risk) as desirable or undesirable.

LEARNING THE TRADE

There are many places where financial analysts and risk managers can find courses to add intellectual decision analysis to their toolbox: universities, local training organizations, industry associations, as well as financial analysis and risk management certification providers. Local training organizations and associations can often provide not only good training venues, but can also provide participants with a networking base within the industry and local market in which these professionals operate.
Any good analyst should first place the basics of financial and statistical analysis in their toolbox to best understand financial statements and the relevant exposures to a particular entity. Once these tools are acquired and practiced, advanced-level research can help refine the analyst into an industry- or field-specific expert, which positions the analyst as more sought-after, more highly paid and increasingly employable. While analytical tool-building provides a good foundation, practical application is the best method for retaining and refining these skills.

Linda Culbertson, business trainer, Financial Analysis and Risk Management Advisor