Managing Risk in a Volatile Economy

Jaydeep Chakraborty


December 3, 2012

The credit crisis of 2008 fueled a global recession that led to falling sales and profits for countless companies. Banks were reluctant to make even short-term loans, and overnight borrowing rates increased. Plants ran at lower capacity, partly due to the squeeze on operating capital and partly due to reduced demand. For companies across the board, conserving cash became the mantra, and a flight to quality in the market meant that institutional investors dumped commercial paper in favor of U.S. Treasuries.

But fortunately, as various central banks bailed out their respective economies, demand increased—at least until the debt crisis of Europe played spoilsport. Now, with profits again swaying with daily economic headlines, virtually all companies are once again facing major financial uncertainty.

The day after the re-election of President Barack Obama, for example, the Dow Jones Industrial Average dropped more than 300 points, something attributed to a lack of confidence that politicians in Washington or Europe will be able to manage their own debts, let alone guide the global economy towards a true recovery. For policymakers and voters, it was a day of major change. For most companies, however, it was just a more of the same.

Understanding Risk—Both in the Good Times and the Bad

The Oxford English Dictionary defines risk as the possibility of financial loss. In finance, however, risk is mathematically denoted by standard deviation, which has an upside in addition to a downside. Therefore, in a volatile economy, when risk and standard deviation become higher than usual, managing risk also rewards firms more than usual, while those who leave their results to chance become all the more exposed.

It is all rather simple: A volatile economy increases the risk of doing business. Risk is ever-present in business, of course, but in a volatile economy, the challenges facing firms multiply and long-term uncertainty makes any strategic planning difficult.

The demand for goods and services fluctuates wildly, for instance. And customers often hunker down into capital conservation mode, perhaps canceling contracts or just reducing existing contract value by renegotiating prices or reducing purchase volumes.

At other times, when the economy is on a temporary upswing, customer demand takes off. This may sound like a better problem to have, but not being able to service this demand can cause a loss in market share, impair customer satisfaction and strain partner relations, which could mean a precipitous drop in “customer lifetime value.”

Another challenge is constraint on the supply side. If current suppliers are unable to manage fluctuating demand and the firm is forced to look elsewhere—perhaps to suppliers with which it has no relationship—the result can be a gap between expectations and delivery. Often, the outcome is lower-quality components that increase the possibility of a recall—something that can, perhaps irreparably, dent a company’s reputation.

One way to mitigate this supplier risk is maintaining high inventory levels. This necessitates higher working capital requirements, however, and can create an uncertainty that increases cycle time and lowers productivity. The result remains undesirable: a higher operating cost for the firm.

Fluctuating interest rates and other macroeconomic factors present a third major challenge. Coupled with earnings uncertainty, it leads to an unpredictable return on capital—something neither lenders nor shareholders ever want to see. Up and down earnings can also affect credit ratings, which again spurs a vicious cycle of effects on the cost of capital.

Lastly, amid uncertainty, firms also struggle to convert credit sales to cash. Cash-strapped customers may take longer to pay, or default, as they try to manage their own liquidity position. And just like that, the customer’s insolvency problems spread up the food chain.

To stay relevant in a volatile economy, and indeed to prosper, firms must understand and mitigate all these risks. The following strategies will help any company navigate the choppy waters.

Align Risk Goals with Business Goals Through ERM

Throughout history, businesses that have delivered consistently have been rewarded by shareholders during volatile times. And in modern times, the businesses that have delivered consistently are the ones with good governance and risk management practices.

Today, enterprise risk management (ERM) is considered the best way for an organization to align risk goals with business goals. As just one example, firms that use ERM are able to implement a Sarbanes-Oxley compliance process that better links the associated risks to its balance sheet. Such reporting processes then do not only comply with SEC requirements;  they also provide the transparency that shareholders covet.

Firms that implement ERM continually revise their risk management practices in the light of emerging risks. Enterprise risk management practices enable firms to not only respond to the risks at hand—be they market, credit or operational—but also to model the impact of future risks on the firm. The benefits are obvious under any circumstances, but as they allow a company to more confidently assess liquidity and maintain appropriate levels of capital,  the upside to ERM can become invaluable when trying to ride out volatile times.

Retain Customers with Pricing

Retaining a customer is far less costly than acquiring a new one. This, especially in volatile times, makes customer retention vital.

Firms must understand that an uncertain time for them is an uncertain time for their customers, too. The peace of mind a repeat customer can provide runs both ways: they will be more likely to give an increasing share of their purse to a familiar business, which in turn is supplied with predictable cash flows just when it needs them most. Long-time partners are also likely to only trust known suppliers with high-margin business—something that companies would give their leg for in tough times.

In any environment, the pricing of goods and services must reflect the value that the customer derives from them. This is doubly true in rough times, when communicating and sharing risk with the customer can build loyalty and enhance customer lifetime value. Businesses that provide specialized products or services—and thus command high margins—should consider ways to incorporate this into their pricing with repeat customers.

The producer of a specialized aircraft part, for example, can consider the frequency of preventive maintenance in its pricing. If its product has a less-frequent maintenance schedule, which means less planned downtime and a lower operating cost for the customer, find a way to build that in.

For firms providing commoditized products or services, however, this strategy is unlikely to work. During volatile times, they have two pricing options: reduce cost while keeping quality constant or provide value-added offerings at the same price. The downside is that both these strategies cut into profitability. To mitigate this risk, companies need to reduce input costs and protect their margin.

Partner With Suppliers on Quality

One of the ways of reducing input cost is managing the “cost of quality.” Quality inputs are the foundation of quality final products, which command greater market share (and better maintain demand in volatile times) and have a lower recall rate than their low-rent alternatives. Maintaining a low recall rate, in particular, enables businesses to keep operating costs low and generally enhances the value of the brand. The “tangible” benefit of this can be represented as the value that goodwill brings to the balance sheet.

On the other hand, detecting defective products in the late stage of production—or worse, at the time of delivery—increases costs, which is just another reason companies should treat their suppliers as partners in quality.

To truly cement a partnership, a firm must create an incentive for their suppliers to maintain high standards. One way of doing that is to increase contract size when the supplies meet the quality standards of the firm. Big contracts with relatively stable order volumes are arguably the best carrot to offer, since it gives suppliers a view into their future earnings and cash flows. It also provides them visibility about the working capital that they would need to meet an order. A stable cost structure and a relatively clear business outlook is cherished—especially in times of volatility.

Manage Liquidity by Converting Credit Sales to Cash

Most businesses extend credit to their customers to boost sales. When the storm clouds are overhead, it is important to convert these credit sales to cash in as short a time period as possible. To do this, firms must have clearly defined contracts with their customers that define the maximum duration allowed time for payment. For most businesses, having an industry standard “master service agreement” helps in this case.

Particularly in volatile times, converting credit sales to cash and maintaining liquidity is prized by lenders. Credit ratings will be enhanced, and the firm will gain access to capital at a lower rate.
Jaydeep Chakraborty, FRM, works as a senior consultant with Cognizant helping clients manage their IT portfolios.