How to Deal with Financing Risk

The discussion about risk in finance quite often deals with the risk incurred by the providers of funds. In this respect the providers of equity are typically those who incur the highest risk: if a firm faces difficulties and is liquidated, equity holders are those who will receive only the very residual money (if any) resulting from the liquidation of the venture. This happens because other providers of funds (e.g. the providers or debt or, in the case of Sharia compliant finance, Mudaraba/Murabaha) enjoy some protection and thus they are not asked to bear any loss incurred by the venture.

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However, also firms incur financial risks depending on their sources of funding. Indeed, except for equity, all the sources of finance entail structured repayment plans that, quite often, cannot be easily renegotiated by the firm. If the firm defaults even just a few payments, it can be forced into liquidation. This implies that it is mandatory to make a detailed analysis upfront in order to have a clear idea about the expected cash flows that the firm or the project will be able to generate.

Any project the firm plans to implement needs finance to fund the purchase the necessary assets. Very often they are financed (at least partially) with debt or Mudaraba. In this case, the repayment plan should be carefully planned so that it can match the cash generated by the firm.

However, a very common mistake is to stop the analysis here. In fact, the new asset will not be able to produce the final output immediately: time will be needed in order to process the material. Then, the firm has to sell the final products and can be asked to provide credit to the buyers in the form of delayed payment. This implies that very often the firm can incur cost (and related cash outflows) before it will sell the product. In other words, this implies that timing can play a key role in determining the financial needs of a firm over and above the finance needed for buying the assets.

These additional financial needs are linked to the working capital, i.e. the finance needed to cover the short term mismatch between cash outflows and cash inflows. The working capital needs are typically covered by short term loans/invoice discounting or, in sharia compliant financial systems, by Murabaha or Salam.

mismatch-between-cash-outflows-and-cash-inflows

As a result before stipulating the purchase contract for an asset (a long term loan or a Mudaraba) as well as for financing short term needs (short term loans/overdraft/invoice discounting or Murabaha/Salam) the firm has to estimate (ideally on a monthly basis) the cash inflows and the cash outflows, where the cash inflows record the income only when the related cash is received and the cash outflows record the cost only when it is paid. This implies that there may be big differences between the monthly net cash flow (cash inflow less cash outflow) and the monthly net margin (income less costs).

Once the monthly cash flows are properly estimated, the firm will have a clearer idea of the short and long term funding needs. The additional information will make it easier to negotiate contracts with the financial institution. More importantly, the conditions attached to the funding can be set up so that they will match the repayment capabilities of the firm. Interestingly, a proper plan will also support the firm in its negotiations with the financial institution as it will provide clear justification for the requested amount and its repayment plans.

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