Strengthening the CFO’s role in strategic risk management to lead Capital intensive business in market volatility
Capital Intensive Businesses
Capital-intensive business exists with lower margins. Management is always expecting Return on Capital Employed (ROCE) above the cost of capital. The major businesses are Oil & Gas, Infrastructure, Construction, IT etc.
Market Volatility Challenges
Market volatility, ceaseless pressure on margins and demanding stakeholders increase the difficulties of thriving in an increasingly interconnected, interdependent and unpredictable global economy.
Many organizations have yet to adapt to this new state of the economic landscape. Doing nothing is no longer an option – they need to adjust and take action now.
Many organizations are now transforming their businesses to strengthen their organization to save costs, create more client-centricity, restore stakeholder confidence and/or embed new business models.
For many organizations, long-term success depends on the success of these transformation programs. To make it more challenging, the margin for error continues to be small, and the environment in which transformation needs to happen continues to increase in complexity.
Strategic Risk Management
• It’s a process for identifying, assessing, and managing both internal and external events and risks that could impede the achievement of strategy and strategic objectives.
• The ultimate goal is creating and protecting shareholder and stakeholder value.
• It’s a primary component and necessary foundation of the organization’s overall enterprise risk management process.
• It is a component of Enterprises Risk Management (ERM), it is by definition effected by boards of directors, management, and others.
• It requires a strategic view of risk and consideration of how external and internal events or scenarios will affect the ability of the organization to achieve its objectives.
• It’s a continual process that should be embedded in strategy setting, strategy execution, and strategy management.
Identifying concrete steps for CFOs to increase involvement in risk management for investment decisions
Concrete Steps to Increase the CFO’s Involvement in Risk Management
• Build a tight link between risk management and other Business Process
• Lead a corporate-level discussion of Risk Preference, Focusing on Risk Choice and select optimal mix
• Use Risk Analytics to communicate investment and strategic Decisions
Build a tight link between risk management and other Business Process
• Focus on foresee issues which will emerging in the future instead of current issues.
• On the basis of prioritization a guidelines to be issued for which Business performance metrics would be effected.
• Business Planners conduct adhoc analysis of upside versus risk, focusing most, if not all, of other attention on a single “Center Cut” scenario.
• Highlighting exactly where and how risk will affect the Business Plan
• Incorporating systematic stress testing using macro scenarios which will reflects possible impact on financial planning
• Applying probabilistic “financial at risk” modeling for major investment decision these efforts. (Cash in hand vs cash needs)
Lead a corporate-level discussion of Risk Preference, Focusing on Risk Choice and select optimal mix
• It is critical to have clear answers to the following questions before making decisions:
o What is the company’s competence in the market?
o Are the decision makers familiar with the risks involved including the tail risks and understand their potential impact?
o Is the company capable of surviving extreme events?
• Risk appetite articulates the level of risk a company is prepared to accept to achieve its strategic objectives.
• Risk appetite frameworks help management understand a company’s risk profile, find an optimal balance between risk and return, and nurture a healthy risk culture in the organization. It explains the risk tolerance of the company both qualitatively and quantitatively.
• Qualitative measures specify major business strategies and business goals that set up the direction of the business and outline favourable risks.
• Quantitative measures provide concrete levels of risk tolerance and risk limits, critical in implementing effective risk management.
Use Risk Analytics to communicate investment and strategic Decisions
• CFO plays an important role in financial and strategic aspects of investments and the evaluation of major decision. He leads the discussion and rival proposals and solutions and often hold powerful decision rights.
• Major Projects with value at stake comparable to total risk from current company operations are discussed and decided with qualitative list of major risks.
• The CFO is ensuring by defining right set of core financial and risk analytics to run for each option to ensure this value stake is brought to light and debated.
EXAMINING LEADING PRACTICES APPLICABLE TO CFOS THAT CAN AUGMENT A COMPANY’S FINANCIAL HEALTH
Best Practices applicable for Company’s Financial Health
CFO have several options to compete more effectively in the Risk Management decisions. Improving returns starts with rethinking where to play-and with four strategic steps that many companies often overlook when it comes to improving performance.
Where to play: A more profit-focused portfolio
• The most pressing issue for leadership teams in capital intensive industries is whether to stay in businesses in which margins have been relentlessly driven down. Many companies are choosing to exit low-profit businesses that once were considered to be core. As they rebalance their portfolios, they are migrating up the value-added chain, investing in related sectors where new technologies can provide competitive advantages.
• Profit pool mapping is an important tool for assessing whether and where it makes sense to do business. In heavy industries, management teams often are so focused on volumes and tonnage that they overlook where the biggest profit pools are. By understanding the sources and distribution of profits across their industry, companies can gain an inside edge on improving returns.
• The premium end of the business typically represents a very large proportion of the profit pool. The best opportunities often cluster there for companies competing in capital-intensive industries.
• Picking the right place to play in the value chain is also critical to improving returns-and the most profitable spot varies across industries.
Best Practices applicable for Company’s Financial Health How to win: Four strategic steps to improving returns
1. Improve the cost base and review capex continually –
• In capital-intensive industries where low returns have become endemic, reducing costs and improving capex efficiency are important ways to improve performance – New developing market entrants in capital-intensive industries have built a strong competitive advantage by keeping capex relatively low. By contrast, the focus on cutting costs at many established players means they sometimes lose sight of improving capex. One way to get the balance right: Develop a more disciplined approach to managing capex, and benchmark the company’s performance against the industry’s leaders.
• Cost discipline makes a critical difference. One-time efforts usually fail to deliver savings that stick, as our research shows. One explanation is that in tough times, management teams are quick to cut costs, but when the cycle swings up, they tend to take their eye off cost improvement and focus on growth-related priorities.
• Developing a rigorous approach to cost improvement and nurturing the right capabilities to optimize working capital can help capital-intensive companies outperform.
2. Build the lowest-cost position
• Geography is another key factor for improving returns. Investing in geographies that offer the lowest landed cost position can create a strong competitive advantage. It’s particularly important in asset-heavy industries where the one-time cost of closing and moving businesses is high.
• The best-performing firms revisit their geographic footprint regularly, as cost dynamics are constantly evolving.
• Companies that can choose the lowest-cost geography up front gain a competitive edge. Those in mature industries need to weigh the short-term downside against the longer-term benefits of reducing complexity.
3. Use mergers and acquisitions strategically
• Smart acquisitions can help improve performance significantly, but many companies get off to a bad start by investing at the top of the cycle, when prices are at their peak, simply because that’s when cash is available. Leadership teams that take a strategic, disciplined and long-term approach to M&A instead of a tactical and episodic approach can improve returns significantly.
• Companies that nurture M&A as a core competence derive the greatest value from them. Their leadership teams devote time to developing a structured roadmap of the most attractive potential targets, making it easier to acquire assets when the right opportunity comes along-and to target acquisitions at the bottom of the cycle.
• Companies that are most experienced in M&A build their capabilities over time. They search hard for merger or acquisition candidates that will add to their operating profit and fuel balanced growth. They pursue nearly as many scope deals as scale deals, moving into adjacent markets as well as expanding their share of existing markets. Most importantly, they create Repeatable Models for identifying, evaluating and then closing good deals. What they typically find is that there are plenty of good prospects to be pursued and that the risk involved decreases with experience.
4. Service ace
• For traditional capital-intensive industries, service can be a highly profitable business in its own right, generating better and faster return on investment than new production facilities, large-scale R&D programs or acquisitions.
• Indeed, for many industrial manufacturers, investing in service is the only way to sustainably grow profits in a tough economic environment. Investing in a service business also lowers capital intensity.
• Investing in a world-class service business can become a strategic ace, elevating a company above competitors in an environment where differentiation on products and cost is difficult to achieve. The range of service opportunities, some larger than others, will vary by industry and company. Here again, mapping profit pools can help identify the potential size of service businesses and those with the greatest returns.
o There is no question that companies in capital-intensive industries operate in a difficult environment today. But leadership teams that commit to a bold ambition have opportunities to break away from the pack and achieve double-digit returns significantly above the cost of capital.
Best Practices applicable for Company’s Financial Health-Getting there requires a strategic shift toward a more profit-focused portfolio:
• Find the most attractive profit pools in your businesses.
• Adopt a mindset of continual cost improvement and capex optimization.
• Look for opportunities to drive down the company’s landed cost footprint by investing in the right geographies.
• Develop strong in-house M&A expertise and a structured roadmap of potential deals.
• Invest in related service businesses
Leadership teams that take these steps will not only give returns a powerful boost, they also will help to rebuild competitive advantage and position their companies to win in a changed industrial landscape.
Reengineering Strategies to improve the link Between Risk Management and Business Planning Process
• Business process reengineering is one approach for redesigning the way work is done to better support the organization’s mission and reduce costs.
• Reengineering starts with a high-level assessment of the organization’s mission, strategic goals, and customer needs.
• Within the framework of this basic assessment of mission and goals, reengineering focuses on the organization’s business processes–the steps and procedures that govern how resources are used to create products and services that meet the needs of particular customers or markets.
• Reengineering identifies, analyses, and redesigns an organization’s core business processes with the aim of achieving dramatic improvements in critical performance measures, such as cost, quality, service, and speed.
• Reengineering recognizes that an organization’s business processes are usually fragmented into sub processes and tasks that are carried out by several specialized functional areas within the organization.
• The CFO Act focuses on the need to significantly improve the government’s financial management and reporting practices. Having appropriate financial systems with accurate data is critical to measuring performance and reducing the costs of operations
Management & Decision Support Structure
• Investigate suggestion for reducing costs and to make them practical and acceptable
• Obtain definite prices and costs
• Present recommendation in comprehensive report
People & Organization
• Organize around outcomes and not tasks
• Have those who use the output of the process perform the process
• Built control in process systems
• Treat geographically dispersed resources
Policies & Regulations
• Develop policies and procedures
• Comply with compliances
• Environmental compatibility
Information & Technology
• Information should go along with the process
• Link all activities
• Capture information at source
• Create reports and real time online updates
Frame for Assessing Reengineering
• Assessing the Organisation’s Decision to Pursue Reengineering
• Reassessing of Its Mission and Strategic Goals
• Identifying Performance Problems and Set Improvement Goals
• Engagement in Reengineering
• Assessing the New Process’ Development
• Appropriately Managing of Reengineering Project
• Analysis of the Target Process and Developed with Feasible Alternatives
• Completion of Sound Business Case for Implementing the New Process
• Assessing Project Implementation and Results
• Following a Comprehensive Implementation Plan
• Executives Addressing Change Management Issues
• New Process Achieving the Desired Results
FOCUSING ON RISK PREFERENCE AND CHOICES FOR CFOs CONSIDERATION TO DELIVER ECONOMIC PROFIT DURING TOUGH CONDITIONS
CFOs need to develop a stronger focus on the economic and performance drivers of their business and need to understand how the effective allocation of scarce resource will help them achieve financial objectives. The CFO must build a performance management capability that can:
• Provide visibility and analysis of information to support resource allocation
• Support the decision-making process by providing the right information to the right people at the right time
• Demonstrate the financial impacts of different decisions and scenarios to enable the organization to predict and compare outcomes
• Incentivize executives and managers to make decisions that maximize marginal contribution
• Enable a data-driven view on resource allocations across the entire value chain (to include corporate strategy; sales, marketing and customer service; supply chain manufacturing and production; finance, HR, legal and compliance)
• Identify the most critical decision points that drive economic performance
With a unique perspective across the entire business, CFOs can provide valuable insight into the decisions that create or protect marginal contribution across the value chain. Armed with a detailed understanding of how and where growth in sales leads to growth in profits, they can offer an objective assessment of fixed and variable costs, and then identify how a reduction in costs can maintain revenues while improving profit contribution.
• Establish a clear, forward-looking line of sight on relevant data for critical decision points
Finance must have access to a robust data set, built around the decisions that drive most economic value in the organization, including assessment of opportunity cost. This demands accurate, verifiable underlying data and an understanding of how the data relates to value chain decisions. This will enable the CFO to conduct scenario planning around these different decision points.
• Develop aligned performance management processes that drive rational decisions
Finance must be able to translate insights and understanding into the desired end product – rational decisions that maximize the desired economic return. Aligning traditional resource allocation processes with business objectives helps ensure repeatability and the sustainability of the organization.
• Ensure compliance and make sure that finance’s voice is heard
The CFO and finance function must be positioned appropriately within the organization to be able to influence decision-making and action. Additionally, finance professionals must improve communication and influencing skills to ensure that their voice is heard and their advice is valued and acted upon.