Globalization and Emerging Risks (Part 2)

Globalisation is good for business. It allows companies to establish a presence in emerging markets that are characterised by robust performances. This geographic diversification also helps insulate companies, particularly in downturn, since any weakness in one area is often balanced out by a better performance in another.

The lessons from the financial meltdown in advanced economies and developed countries are extremely valuable. While trading with each other, the financial institutions in these economies became so interconnected and dependent on each other and failed to identify and manage the risks inherent in such a scenario. They traded in each other’s complex financial instruments, reaped massive profits from the trades and rewarded themselves handsomely.

Once the pinnacle of these excess profits, the property bubble came to a screeching halt in the summer of 2008. Capital markets (normally the source of funding for institutions) dried up, consumers defaulted on their mortgages and the aftermath was a severe global economic downturn. The era of cheap money had come to an end. Some of the biggest financial institutions ceased doing business overnight, some found themselves drooling for taxpayers funds to keep them in business and millions of employees lost their jobs.

From the above economic events, we can learn that business has always and still involve risk. While formulating and implementing business strategies, managers should understand the relationship between risk and return. To best manage the risks inherent in business, there is need to have access to information on markets and counterparties. This will help identify various risks and implement measures that lead to success.

Three important risks come to light and should not be ignored when formulating and implementing business strategies. If ignored and not managed properly, the knock-on effect on business operations is so severe that the business could be brought to its knees. The risks are:

1. Market Risk: This is the risk of market price changes especially interest rates, foreign currency exchange rates, share prices and inflation rates on the operations of the business. Changes in these macro-economic indices have an impact on cash flow and profits of the business. Managers should have the ability to establish how changes in one of these parameters in one geographical location will impact the bottom line in another. For those firms that depend heavily on leverage, a sharp rise in interest rates will eventually lead to a rise in finance costs as the costs of servicing debt becomes unbearable. In the US, a long period of low interest rates flooded the country with cheap money. Most companies became heavily geared but when the stock markets tumbled, the consequences were catastrophic.

2. Operational Risk: Humans and systems can fail. As advanced technological developments continue to change the shape and course of various business models, rather than focus on the pros only, there is also need to concentrate on the cons of such investments. A breakdown in an organisation’s ERP system can have a damaging effect on the bottom line. Since the onset of the global financial crisis, according to KPMG’s fraud barometer, the number of fraud cases has risen sharply. This also negatively affects the operations of the business as well as its reputation.

A case in point is that of Bernie Madoff who is now serving a 150 year jail sentence for orchestrating the most historical investment ponzi scheme. Not only did investors flee his business, his reputation was also destroyed instantly. The same could happen to your business regardless of which sector you operate in. One malicious act by an employee can bring your empire down instantly. It is very important to have fraud mitigating measures in place to limit the severity of such acts. External events can also disrupt operations. When managing such risks both a qualitative and quantitative approach should be taken.

3. Credit Risk: This is the risk of the counterparty defaulting. Credit risk management is key to successful cash flow management. When the stock market went down in the US, firms that had always relied on rising markets for finance woke up to find themselves in deep waters. Many had to deal with working capital problems and this in turn disrupted various supply chains. Positive cash flow is vital for the health of your business. The problem arises when your customers start running into financial difficulties and become unable to pay invoices. This can push the business over the edge.

Your company’s credit policy is very important. There is need to check the creditworthiness of your potential and existing customers before effecting any order. Credit rating agencies could be your first stop as they are able to provide you with information on financial results, payment experience of other suppliers, county court judgements, registered lending and a recommended credit rating. Obtaining credit insurance is another way of managing credit and exposure to customers.Though credit insurance is commonly used in international trading, where chasing and recovering cash from customers is much harder, taking out this kind of policy will help you cover either individual accounts or your business’s entire turnover

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