Corporate treasurers face an array of financial market challenges today, including interest rate, foreign exchange, commodity and inflation risk. How companies cope with these risks depends on the extent to which they adopt a comprehensive risk evaluation strategy. In this Product Profile, we speak to Jwan Mella, Director, Financial Risk Advisory – Capital Markets at Lloyds Bank, about his team’s process for assessing – and minimising – the impact of financial market volatility on a company’s bottom line.

When a company uses any form of financing, there is an inherent risk that it will not have sufficient cash flow to meet its financial obligations at a given point in time. This may happen for a variety of reasons but the most common financial threats are market-related.

Take interest rate risk for example. In the long term, interest rates are likely to increase from the current low levels. For a company that is a net borrower, the single largest interest rate risk will be the servicing of debt. An increase in interest rates (however large) would likely mean higher interest payments and repayment costs. If, on the other hand, a company is cash rich, it can be exposed to the risk that interest rates will decrease and impact the size of the yield on its investments, as we are seeing currently.

In either case, interest rate exposure constitutes the danger of reduced cash flow, whether in the form of diminished cash inflows or increased cash outflows. Therefore, the main danger resulting from interest rate risk is that a company could face liquidity problems. In the worst case scenario, loan covenants such as minimum interest cover ratios could be triggered by rising interest rates, which in turn could translate into higher borrowing costs as a result of financial distress.

Also, it is often assumed that fixed rate financing does not carry any risks from interest rate changes. However, while fixed rate debt might provide the security of certain repayment rates, a fall in interest rates would result in opportunity losses because the company cannot benefit from improving interest rates.

But with so much to contend with on a daily basis and staffing levels only decreasing, how can treasurers find the time to properly answer niggling questions such as, ‘Will the company be able to readjust to paying more for its borrowings when rates begin to rise again? Would it be wise to shift from floating to fixed costs or vice versa?’ This is where Lloyds Bank’s Financial Risk Advisory team comes in.

“We work alongside our clients to help them to assess the impact of financial market volatility on their bottom line profit and key performance metrics. One of the tools we use to do this, within our comprehensive financial risk framework, is the financial risk evaluation process. Essentially, this is a customisable series of models which combine a company’s financial projections with financial market uncertainty,” explains Jwan Mella, Director, Financial Risk Advisory – Capital Markets at Lloyds Bank.

The models are used to look at strategy optimisation (by providing feedback on a company’s debt structure, for example), as well as concerns such as refinancing risk or the cost impact of a change in strategy, such as mark-to-market crystallisation. “In other words, the risk evaluation process sits between a rudimentary analysis of a company’s risks and a wider financial risk analysis encompassing the impact of any foreseeable financial risks.”

Putting the process into action

Typically, the process of creating a financial risk report for the client begins with an initial meeting in which the client and the bank discuss the Financial Risk Advisory team’s approach, as well as the model itself and what is required. Says Mella: “We engage with stakeholders at the strategic level and extract the driving factors for a company’s financial risks. These risks, in many cases, are implicit and not obvious from the outset.”

“Once we have determined that our process is the right approach for the client’s needs, we work closely with them to run the simulations, based on the market factors we have agreed, and in looking at their business strategy.” To do this, the client is required to provide a certain level of company information. For a base level analysis, for example, the following information will be required: historic financial information going back at least five years (or an established record of how a company will perform relative to financial markets); income statement projection; cash flow statement projection; balance sheet projection; debt and refinancing projections; current debt structure; any mark-to-market or existing derivatives contracts.

Next steps

Once the data has been assembled, the starting point is to look at the company’s cash flows, balance sheet and their strategic horizon. “We also look at the company’s cash or funding levels, as well as their debt structure and how those progress over time. This takes into account the company’s own assumptions about their refinancing needs and overlays financial risks, such as the fact that the company’s revenues may be partially linked to inflation for example.”

Take a property company for example. We would look at property indices and layer them into a Monte Carlo simulation. Then we stress the revenue – we do this largely through historic information and back testing revenue movements according to stress levels. We can look to pin down the significance of the correlation first of all and then we look at how persistent the effect is, or whether there is a lag.

Mella continues: “Take a property company for example. We would look at property indices and layer them into a Monte Carlo simulation. Then we stress the revenue – we do this largely through historic information and back testing revenue movements according to stress levels. We can look to pin down the significance of the correlation first of all and then we look at how persistent the effect is, or whether there is a lag.”

“We can also assess whether the revenues are correlated to specific movements in a certain commodity. This can then help the company to make sure its pricing structure is correct, so that it can absorb any increases in the price of that commodity.” Other metrics that are stress tested include: operating expense, net interest expense, EBITDA, leverage and interest cover. The results are then represented graphically:

Source: Lloyds Bank

What the interest cover ratio distribution in the chart shows is that there is a high probability that the company in question will be able to fund operations over the strategic ten year horizon.

However, there is a small chance that the interest cover ratio approaches 1.0x over the horizon.

Once the relevant risk metrics for the company have been assessed, we then look at performance measures and risk tolerances. What are the limits the company wants to work to and what are the worst case scenarios it will tolerate? “Setting the risk tolerances is extremely important and there are a number of points that companies often overlook.

These include benchmarking against the correct peer group; taking into account covenant headroom; and assessing the overall viability of the business strategy” says Mella. Lloyds Bank can then overlay that onto the company’s balance sheet and income statement for example and show what those performance limits would mean in real terms for the company’s bottom line.

The next step in the process is to determine the best debt structure for the company. What is the optimal level of fixed/floating debt for example? In situations where the results from the analysis are straightforward, a decision making/strategy comparison grid can be produced (see table 1).

The overall aim of this process is to move the client towards a strategic risk management approach. Strategic risk management is designed to: identify the risks that could impede or stop normal business operations; highlight the extremes of market volatility and how they affect the bottom line performance of the business; suggest an optimal capital structure and hedging benchmark to mitigate or remove the risks to which the business is exposed; when the financial market exposure is varied, complex or partially offset, an optimisation across different metrics is required.

Optimisation

Once the appropriate strategy has been determined, it is time for optimisation to begin. This involves another charting exercise, called ‘optimal frontier analysis’.

What charts 2 and 3 show, says Mella, is that “in this example, by the nature of the business there is a strong link to inflation, where assets, and in turn income have a large inflation component. The company’s inflation risk is partly mitigated by implicit and explicit inflation linked components in the operating expense. However, as the optimal frontier shows, on average, over a ten year period, the company can benefit from having up to 20% of the debt linked to inflation. Additionally, 10% floating linked debt lowers the interest rate worst case profile.”

Each blue point represents a different proportion of fixed, floating and inflation linked debt.

Source: Lloyds Bank

Source: Lloyds Bank

“Floating rate debt in the very short term offers cost savings, but over the strategic horizon can introduce high volatility around key metrics. A highly fixed debt structure offers funding cost certainty, but no natural synergy with the business. It is also worth noting that mark-to-market of fixed rate debt is included when switching to inflation and floating.”

Often clients come to us as they are looking for analysis to take to their Board. Through the process and the team’s expertise, what Lloyds Bank offers is an extra layer of granularity over a company’s exposures and optimal strategies.

The same ‘optimal frontier analysis’ is then conducted on other key metrics, such as cash levels and earnings. To converge onto an optimal fixed – floating – inflation debt mix, the opportunities and the risks are then explored together. The opportunities include: lowering funding costs; aligning debt structure with asset and income structure; and flexibility. The risks include: the maintenance of key ratios and funding cost volatility.

Strategy validation

The final step in the process is to validate the strategy. For example, charts 4 and 5 illustrate that under the base scenario the company is expected not to be cash generative in the short to medium term. The expected cash levels are below zero over most of the strategic horizon. By moving more of its debt to be inflation-linked however, the company can skew the distribution higher to limit any downside moves in cash.

As such, the optimisation is validated since “increasing the level of floating rate debt and including some inflation linked debt raises the expected cash levels and narrows the uncertainty around the distribution.”

Source: Lloyds Bank

Source: Lloyds Bank

Added-value

“Often clients come to us as they are looking for analysis to take to their Board. Through the process and the team’s expertise, what Lloyds Bank offers is an extra layer of granularity over a company’s exposures and optimal strategies. The findings of our modelling might, for example, give the treasurer the ‘ammunition’ they need to have a discussion around amending the company’s hedging strategy – or indeed they might confirm that what the company is currently doing to manage and mitigate its financial risk is sufficient,” he continues.

The team also frequently undertakes follow-up projects that stem from the initial work produced for the client.

According to Mella, the model is applicable to all corporates. For smaller corporates, the bank might simply look at their debt profile, or a specific scenario. For the larger, highly sophisticated clients, there is the ability to dig much deeper – the client might have an obscure risk measure it wishes to use or, of course the company might want the whole picture of its risks analysed in order to outline the optimal risk management strategy.

As Mella’s team touches on every product area, they take a joined up approach to looking at a company’s funding strategy, with products to back up the findings of their risk evaluation. This includes everything from derivative products to debt structure. The team also frequently undertakes follow-up projects that stem from the initial work produced for the client.

“We might update previous analysis with new market information for example, or the company might have internal or external advisory capabilities with which they want our process integrated. Typically, our strategic evaluation work is 100% bespoke. Our aim is to always provide tailored, in-depth intelligence to the client to assist them in creating a long-term financial risk management strategy.”

Lloyds Bank Wholesale Banking & Markets

Lloyds Bank, part of the Wholesale Division at Lloyds Banking Group, provides comprehensive expert financial services to businesses, from those with over £15m annual turnover to those with turnover in the billions. It has over 26,000 corporate clients, ranging from privately-owned firms to FTSE 100 PLCs, multinational corporations and financial institutions.

It has a network of relationship teams across the UK, as well as internationally, with the mix of local understanding and global expertise necessary to provide long-term support and advice to its customers.

Lloyds Bank offers a broad range of finance, spanning structured and asset finance, import and export trade finance; securitisation facilities and capital market funding. Its product specialists provide bespoke financial services and solutions including tailored cash management, international trade, treasury and risk management services.

Its heritage means it has an unrivalled understanding of business needs and a proven track record of supporting customers across the sectors and regions. Taking a relationship approach, it provides support to its customers throughout the economic cycle.