Balancing the risk: how to develop effective financial strategy

Balancing the risk: how to develop effective financial strategy

If you’ve undertaken to compile the financial strategy for your business, you’re tasked with setting the scene for the financial future of the company. It’s a mammoth duty, and one that should be undertaken with plenty of forethought and a degree of caution.

Your company’s financial strategy is derived from its mission. It should be a living document that ultimately guides the strategic direction of the company and many decisions made by senior management. But if it is not done effectively or doesn’t enjoy buy-in from other managers and staff members, it can also be a meaningless report that gets ignored in favour of ad hoc decisions that are later regretted.

‘Risky’ business

A powerful financial strategy should provide a blueprint for the business risk that the company plans to take. Academics Ruth Bender and Keith Ward put it succinctly. “The basic principle is really simple,” they say in their book Corporate Financial Strategy. “Businesses need to take risk – without risk there is no opportunity and no reward. But taking too much risk can destroy the organization.

“Risk comes from business activities as well as financial strategy, and therefore the decision on how much financial risk to take will depend fundamentally on the characteristics of the business.”

When developing financial strategy, two scenarios should be avoided. First, an instance where there is high business risk and high financial risk (that is, where the company is in high levels of debt). Conversely, a scenario wherein both business risk and financial risk are low, is also undesirable. In the first case, growth would be unsustainable and the chances of the company folding and owing huge amounts to investors is high. In the second case, growth is likely to be stagnant and insufficient to develop meaningful returns.

A discerning financial strategy notes the level of business risk inherent in the company’s business model. It then pitches a level of financial risk that helps to balance this out and ensure longevity for the business.

Let’s say your business idea involves selling a brand new farming technique to rural farmers in Croatia. As a South African company, you’re entering a relatively untested environment, and one that could involve long lead times before any sales are made. Such a venture involves high business risk. Your accompanying financial strategy should mitigate this by prescribing a low to moderate level of financial risk. Your financial strategy should stipulate low initial capital outlay for such a venture, and not be overly reliant on investor backing to meet objectives or break even.

On the other end of the continuum, you could be strategizing for a very low risk business venture. For example, your company could have sprung up in response to a demand for consulting services requested from several large clients. You already have guaranteed income and a proven client base. Your business might see aggressive growth as the right way forward, and your financial strategy would recommend higher levels of capital outlay in order to achieve this. The risk would be mitigated by a higher chance of return on investment and the fact that capital requirements are inherently low for consulting companies.

Life cycle concerns

The level of risk outlined by your financial strategy should also be cognizant of the life cycle of the business. Bender and Ward suggest this as a rule of thumb:

  • Early stage businesses: Ventures where outcomes can be guessed at but are ultimately unknown should not be financed with debt. Businesses at the launch phase should be financed with equity such as venture capital; in other words, equity that is prepared to accept high risk. Your financial strategy should outline possible sources of such equity.
  • Growth stage businesses: Here, risk remains fairly high in most cases. Because of this, debt should likewise be avoided. Ward and Bender suggest that the financial strategy for a company outlines finance in the form of equity taken from capital markets.
  • Mature businesses: Business risk for a company at this stage in the life cycle is lower. At this point, the company’s financial strategy should aim to bring down the cost of capital. It does this by outlining a path of cheap debt, rather than the previously required expensive equity.

An insightful financial strategy takes risk considerations into careful consideration when mapping out the way forward for the business. If you are looking for someone who is able to identify what level of risk should be incorporated into your financial strategy, The Finance Team can assist by providing an experienced finance executive to help with the process on an interim or part-time basis.

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