Risk Management and Finance
If you are in finance, you are a risk manager. Say what? Risk management! Imagine being the hub in a spoke of functional areas, each of which is embedded with a risk pattern that can vary over time. A sound finance manager would be someone who would be best able to keep pulse, and be able to support the decisions that can contain the risk. Thus, value management becomes critical: Weighing the consequence of a decision against the risk that the decision poses. Not cost management, but value management. And to make value management more concrete, we turn to cash impact or rather – the discounted value of future stream of cash that may or may not be a consequent to a decision. Companies carry risks. If not, a company will not offer any premiums in value to the market. They create competitive advantage – defined as sorting a sustained growth in free cash flow as the key metric that becomes the separator.
John Kay, an eminent strategist, had identified four sources of competitive advantage: Organization Architecture and Culture, Reputation, Innovation and Strategic Assets. All of these are inextricably intertwined, and must be aligned to service value in the company. The business value approach underpins the interrelationships best. And in so doing, scenario planning emerges as a sound machination to manage risks. Understanding the profit impact of a strategy, and the capability/initiative tie-in is one of the most crucial conversations that a good finance manager could encourage in a company. Product, market and internal capabilities become the anchor points in evolving discussions. Scenario planning thus emerges in context of trends and uncertainties: a trend in patterns may open up possibilities, the latter being in the domain of uncertainty.
There are multiple methods one could use in building scenarios and engaging in fruitful risk assessment.
1.Sensitivity Assessment: Evaluate decisions in the context of the strategy’s reliance on the resilience of business conditions. Assess the various conditions in a scenario or mutually exclusive scenarios, assess a probabilistic guesstimate on success factors, and then offer simple solutions. This assessment tends to be heuristic oriented and excellent when one is dealing with few specific decisions to be made. There is an elevated sense of clarity with regard to the business conditions that may present itself. And this is most commonly used, but does not thwart the more realistic conditions where clarity is obfuscated and muddy.
2.Strategy Evaluation: Use scenarios to test a strategy by throwing a layer of interaction complexity. To the extent you can disaggregate the complexity, the evaluation of a strategy is better tenable. But once again, disaggregation has its downsides. We don’t operate in a vacuum. It is the aggregation, and negotiating through this aggregation effectively is where the real value is. You may have heard of the Mckinsey MECE (Mutually Exclusive; Comprehensively Exhaustive) methodology where strategic thrusts are disaggregated and contained within a narrow framework. The idea is that if one does that enough, one has an untrammeled confidence in choosing one initiative over another. That is true again in some cases, but my belief is that the world operates at a more synthetic level than pure analytic. We resort to analytics since it is too damned hard to synthesize, and be able to agree on an optimal solution. I am not creaming analytics; I am only suggesting that there is some possibility that a false hypothesis is accepted and a true one rejected. Thus analytics is an important tool, but must be weighed along with the synthetic tradition.
3.Synthetic Development: By far the most interesting and perhaps the most controversial with glint of academic and theoretical monstrosities included – this represents developing and broadcasting all scenarios equally weighed, and grouping interaction of scenarios. Thus, if introducing a multi-million dollar initiative in untested waters is a decision you have to weigh, one must go through the first two methods, and then review the final outcome against peripheral factors that were not introduced initially. A simple statement or realization like – The competition for Southwest is the Greyhound bus – could significantly alter the expanse of the strategy.
If you think of the new world of finance being nothing more than crunching numbers … stop and think again. Yes …crunching those numbers play a big part, less a cause than an effect of the mental model that you appropriate in this prized profession.
Posted on August 21, 2012, in Financial Metrics, Risk Management and tagged finance, model, risk management, scenarios, strategy, uncertainty, value management. Bookmark the permalink. Leave a comment.