Assessment and Management of Financial Risk in Romania

Aprilie 2009

IULIAN SORESCU - Associated Partner, Head of Financial Department THI AUDIT ROMANIA S.R.L.

Nowadays, more than ever, Romanian companies should look into the mirror, self analyze and change their approach on doing business in order to cope with difficult times ahead.

Risk assessment is mandatory to be undertaken by Romanian companies in order to identify to what extent they are exposed in the current challenging environment. And they are significantly exposed, as long as they do not have previous experience of dealing with crises. Real experience in the market economy was gained only after the revolution from 1989 and although the first years were also very tough for the business, they cannot be compared with a crisis coming after a booming period. Having done such assessment, Romanian companies should evaluate the magnitude of the risks inside their organisation and take preventive or corrective measures.

Few years ago, the assessment of the risks was normal to be done yearly and sometimes twice per year, but now, when things are changing dramatically from one month to another, Romanian companies should consider it on a monthly basis. In the past, Romanian companies used to prepare a yearly budget and deviations from that budget were, in most of the cases, not significant, due to predictability of the economic business, and if so, most of them faced positive deviations. A yearly budget is now a huge error and monthly/quarterly rolling budgets are more relevant to be prepared.

 

Liquidity risk

Beside the business risk that is more or less easier to be managed by the company, the financial risk is the one that can be controlled and managed by Romanian companies based on a detailed and tailored plan. Such plan should cover the liquidity risk, the interest risk, counterparty risk, currency risk and, why not, accounting risk.

Companies monitoring carefully the liquidity risk by reacting at each deviation from the planned target are now less affected by the liquidity shortage present in the worldwide economies.

Assets risk is one important component of liquidity risk, being met in practice in cases where companies have blocked money into non-liquid assets. Beginning of 2009 showed a Romanian real estate market almost blocked by buyers facing the cash shortage and waiting for lower prices, on one hand, and sellers realizing that the demand for their assets is very small, on the other hand. Thus, a blocked market now places the company in the position of not being able to improve the cash position by selling those assets and looking desperately for alternative solutions of financing. The escape can sometimes come from financing companies, that still have budgets for sale and lease back or sale and rent transactions. However, even for such financing scheme, that offer more comfort to the lender than a simple financing operation, lending companies do not have too much money available during these days and the conditions for accessing financing are stricter.

As working capital risk is easier to be mitigated, it is necessary to detail what working capital is, namely the difference between current assets and current liabilities. Working capital is considered a part of the operational capital and therefore, positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short term debts and upcoming operational expenses.

Activities that are regularly monitoring the working capital level are a must for each company, especially during these days. Most companies that are generally taking care of the working capital are the Romanian subsidiaries of multinational companies or large local companies, for which such matter is part of their controlling procedures. You will now ask about small and medium sized Romanian companies. During the last years, most of them did ignore it and did their business according to their feelings. We really hope that they shaped this approach in the last years and sharing employees with the multinational companies contributed to transferring of the controlling knowledge also.

A very simple way for keeping the working capital under control is by monitoring the financial ratios receivable days (number of days of transforming the receivable into cash), payable days (a measure of the average time a company takes to pay its suppliers) and inventories days (average number of days goods remains in inventory before being sold).

Moving further, the process of analyzing the working capital include the activities of monitoring accounts receivable, inventories and accounts payables. Most of management say it is an accounting task, but this is a big mistake as the accountants are generally dealing with figures only, and sales/procurement departments and top management are those involved in the day-to-day business. Thus an effort of the whole team is necessary for a successful result.

A good management of working capital will generate cash, improve profits and reduce risks.

Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial part of the firm’s total profit.

Collection of receivables is today one of the trendy activity for the Romanian companies. Some of them that already developed appropriate procedures for handling late payments by tracking and pursuing the late payers, or getting external help if their efforts fail are now already prepared for the fight. They will now focus on various strategies like selling only for cash, offering early payments discounts or renegotiating contracts to include up-front and progress payments instead of getting paid just at the end of the job.

Let’s take an example relevant for the magnitude of impact of bad debts over the business: a business selling 10% margin goods (i.e. sales of 110 and cost of sales of 100) does not cash in the related receivables. It does not mean that the loss for the company is only 10, but also the cost of sales of 100. And the question is “How much should the company sell in order to recover the loss of 110?” The answer is predictable: “10 times more, due to the 10% gross margin, meaning 1100!”. Looking the business outside, it looks disastrous to sell 10 times more to cover the loss from not recovering a single customer. Moreover, the above mentioned results are true as long as the 10 times more sales are also cashed in full. Romanian companies should have learned this lesson during the last years and not make such simple errors.

Moving further to payables, creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. It is the time to renounce to the over-zealous purchasing function of paying invoices immediately after their notice just for solving one more task from our to do list. As a result, Romanian companies should consider the following in order to improve the creditors’ management:

• Who authorizes purchasing – is it tightly managed or spread among a number of persons that are not monitorized?
• Are purchase quantities/services geared for demand forecasts?
• Does the company analyze the alternative sources of supply? If not, get quotes from major suppliers and shop around for the best discounts, credit terms and reduce dependence on a single supplier.
• How many of your suppliers have a returns policy?

Expenditures should be verified as soon as the goods or services have been acquired and booked immediately into the accounts. Finally, do not forget the old motto: If you can buy well, you can sell well.

Managing inventories is another important activity of companies, especially for distributors and manufacturers. Excessive stocks can place a heavy burden on the cash resources of a business, while insufficient stocks can result in lost sales and delays for customers. So, optimization of inventories is crucial, especially during these days. We remember about companies holding a high level of inventories before the liquidity crisis and now being in huge difficulties to sell them due to the high cost of acquisition. It is about automotive industry, companies acting in construction materials and generally those acting in connected businesses seriously affected by the economic downturn, whereby the selling price decreased dramatically at the end of 2008.

There are technical methods for improving inventory management, like economic order quantities, just in time or product life-cycle analysis, but these are more complex and will be detailed in future articles.

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