Why Managers Benefit from a Healthy Appetite
My time on calls and in meetings with CFOs and corporate treasurers often leads to the same conversation at the moment; nearly all of them are worried about their firms’ capital allocation processes. The main reason for this is that they lack confidence in their colleagues’ appreciation of financial risk appetite.
This is backed up by a survey we did earlier this year of over 100 of the world’s largest corporate treasury groups (for Treasury Leadership Roundtable (TLR) members), where only 18% of treasurers agreed with the statement that, “Business unit management understands our firm’s financial risk appetite.”
This lack of understanding causes problems on both sides of the capital allocation equation: with capital supply and capital demand. On the capital supply side, it is not easy in the volatile post-recessionary environment for finance teams to ascertain how much risk they should take in securing funding from different sources, and it is also not easy to explain these different levels of risk to their business partners.
On the other side of the equation – capital demand – is the fact that both senior and business-unit level managers find it hard to make good capital allocation decisions. Boards and senior managers are caught between investing cash in capital projects, holding additional liquidity as protection against future shocks, and returning excess cash to shareholders (we’ve given our advice on this conundrum in earlier blogs). Firms need to align capital supply and capital demand decision-making much more closely together and, to do this, senior managers should ensure that the firm’s risk appetite is communicated throughout the organization.
It is not just the conversations we’re having with corporate treasurers that convinces us of the need for this alignment. As our own research shows, firms that tightly correlate treasury process (capital supply) with broader business process (capital demand) not only perform better across the long-term but work with a lower weighted-average cost of capital (8.95 versus 9.97) as well.
In such a volatile operating environment finance teams need to create a ‘virtuous circle’ of assumption testing and correction in both their liquidity and capital planning processes. We see leading finance teams doing two things in particular:
- Incorporate business risk scenarios into the liquidity plan: Express recognizable enterprise risk scenarios in terms of their effect on liquidity. Also spell out the cash impact of contingency plans to clarify risk tolerance and appetite.
- Reconcile capital supply and demand plans: Take an integrated approach to capital planning in which treasury analysis on capital availability is conjoined with planning and new business development analysis on future capital requirements.
This ensures that operational teams that know their area of the business understand what investment decisions they should consider viable (and what are considered too risky), and that senior management are kept abreast of emerging risks in different business lines. TLR members can read about this in a lot more detail here.
It also ensures that treasurers and finance teams are not overly risk averse in their liquidity planning. As we know well, firms that perform poorly after recessions are those that are overly scared of the new operating environment; they are forever defending against the last crisis rather than sensing and adapting to the current landscape.
All in all, then, risk appetite is an important concept for employees at all levels to understand and use. CEB clients should contact me to discuss any of this.