Cash Flow Risk Management and How to Reduce Risk
Last Updated on October 28, 2021
In any business, cash flow, which is the amount of money that moves in and out to determine the value of the business, causes entrepreneurs sleepless nights.
Because a business is exposed to several uncertain financial issues, cash flow risk can come in many forms. These include competitive, industry, or financial cash flow risk, resulting in the inability of a business to acquire the funds necessary to operate.
Read on to learn some examples of cash flow risk, common causes of cash flow risk, and the ways you can minimize and altogether avoid cash flow risk.
Examples of Cash Flow Risk
Below are some interesting examples of cash flow risks:
Risk from Operating Activities
Cash flow risk from operating activities happens when the amount of cash you receive from your operations is less than all expenditures and bills from the sales. It means you are spending more than you are gaining.
Risk from Investing Activities
In order to offset the deficit from the above example, you might obtain cash from the sale or lease of long-term assets, property, or equipment that you had invested in to maintain or grow your business.
The process of selling these long-term assets can result in liquidity risk. It may even escalate to another cash flow risk.
Risk from Financing Activities
Cash flow risk from financing activities occurs when you obtain cash to balance out the two cash flow risk examples mentioned above. The cash can be in loans, money issued from bonds and shares, or money issued out by shareholders.
However, this cash flow risk still leaves you with a gap to fill. And this gap comes in yet another form of risk.
Risk from Free Cash Flow
After deducting all liabilities and obligations, the net profit you get is usually obtained by subtracting cash flow from investing activities from operating cash flow.
This “true” profit is used to pay for the cash flow risk from financing activities. The result is a continuous cycle of cash flow risk. A question that begs to be asked is “What causes cash flow risk?”
What Causes Cash Flow Risk?
Below are some common causes of cash flow risk: Note, these risk causes are intertwined. What’s important is understanding them and coming up with appropriate solutions.
High Expenditure Compared to Sales
Expenses, especially unplanned ones, are variables that cause cash flow risk. An example is when machines or equipment break down and require immediate fixing lest operations are halted. The cost of such repair is usually very high.
Slowing or halting operations leads to the following cause of cash flow risk.
When products are not moving, that’s cause for immediate cash flow risk.
Then to improve sales, you likely come with methods such as selling on credit, leading to yet another cause of cash flow risk.
Bad Receivable Collection and Bad Debts
Selling on credit is expected to generate an expected cash flow, but this is not always the case.
Debtors might breach their repayment terms by paying late or not paying at all. This accumulates to bad debts. When that happens, since the cash flow is unreliable, it spurs a decision that leads to more cash flow risk.
Bad Pricing and Negative Gross Margins
Selling products at low prices to gain quick cash flow is not advisable. That’s because the cost of production remains the same.
For that reason, such a situation directly correlates to the first cause of cash flow risk—high expenditure compared to sales.
Incorrect sales forecasting leads to a business having excess stock in its warehouses. What they have projected to sell has not moved in that period.
Low sales or other market factors can cause such a situation. With an excess inventory that is not moving, cash flow from operations is at constant risk.
Every business has a peak. And while peak periods are excellent for improving sales, they come with additional costs, such as the need to increase staff and stock.
Subsequently, when your business is not at its peak, dealing with the additional staff and paying suppliers can put your cash flow at risk.
How Can Cash Flow Risk Be Avoided or Mitigated?
Here are some ways of reducing or avoiding cash flow risk:
1. Using the Cash Flow at Risk Process (CFaR)
You employ this process to:
- Identify the exposures to the business.
- Enshroud market-related results
- Model the Risk
- Generate findings
- Determine effect to the business
2. Estimate the Value at Risk (VaR)
Estimating the VaR over a given period enables you to have the flexibility to adapt to any rising cash flow risk by considering the CFaR process.
3. Have an Emergency Cash Reserve
Having an emergency cash stash can help you avoid misinterpretation of sales forecasts, leading to cash flow risks.
4. Perfect Your Cash Flow
Giving incentives to debtors, such as discounts for early repayments, and negotiating new flexible terms with suppliers, ensures a steady cash flow.
Also, check the credit ratings of your debtors to avoid bad debts from accruing.
This is the most difficult but necessary process for any business. It ensures you have an in-depth view of the cash flow in your company. It also gives you the power to plan, manage, and cut unnecessary costs.
In short, knowing the relationship between each example of cash flow risk and how their causes influence each other in a loop will help you mitigate and avoid the cash flow risk you might face when you start or expand your business.
Frequently Asked Questions (FAQ)
What Is Cash Flow at Risk (CFaR)?
CFaR is defined as the potential future probability of which cash flows may not be expected arising from market variables.
What Is Value at Risk (VaR)?
A statistical measure is used to estimate the value at risk that may occur in a firm or portfolio investment over a specific period.
What Is Liquidity Risk?
This is the risk of being unable to sell or buy fixed assets without affecting the asset’s price during a given period.
It is vital to know the relationship between each example of cash flow risk and how their causes influence each other in a loop. It will help you mitigate and avoid cash flow risk.
You need an effective system in place. A good system for managing cash flow risk should identify potential risk exposure, valuate risk exposure, and prepare forecast budgets for cash flow risk emergencies.