Managing risk

Managing risk

Important information: As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on this advice, consider its appropriateness to your circumstances. Product Disclosure Statement issued by Commonwealth Bank of Australia ABN 48 123 123 124 for Foreign Exchange Service is available on request and should be considered before making any decision about this product. Applications for finance are subject to the Bank’s normal credit approval. Full terms and conditions are included in the Loan offer. Bank fees and charges are payable. Financial markets’ products contain an element of risk: the level of risk varies depending on the product’s specific attributes and how it is used. The Bank will enter transactions on the understanding that the customer has: made their own independent decision to enter into the transaction; determined that the transaction is appropriate; ensured they have the capacity to evaluate and understand the terms, conditions and risks, and is not relying on any communication or information from the Bank as advice.

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Managing risk | 1

Contents

Coming to terms with risk 2

Risks to your business 2

Interest rate risk 3

Fixed rates, caps, collars and combos 3

Developing a strategy 3

Case study – managing interest rate risk 4

Currency risk 6

Developing a strategy 7

Import and export risks 8

Choosing a payment method 8

Trade finance 9

Developing a strategy 9

Case study – managing import and export risks 10

Risks to people and assets 11

Protecting key people 11

Protecting assets 11

Developing a strategy 11

Talk to us 13

2 | Managing risk

Managing risk

Coming to terms with risk

Risk is an inevitable part of doing business. But that doesn’t mean it can’t be managed.Everyone who runs a business knows that opportunities always involve some risk. After all, risk is simply uncertainty – and every business venture has the potential to surprise us either on the upside or the downside.

As your business grows, the risks you face also grow. Not only do you have more at stake, but the increasing complexity of your business makes risk harder to manage. That’s when you need a robust risk management plan.

The aim of risk management is to protect your business and give you greater certainty when planning for the future. It can come at a cost. Not only are there the direct costs of putting risk management measures in place; but, depending on the approach you take, there can also be opportunity costs, since greater certainty can sometimes mean less opportunity for profit. The key is to choose a strategy that protects you from the downside while still giving you an opportunity to benefit from the upside.

This guide is an introduction to some of the most significant financial risks your business may face. Your business faces a unique set of risks and possibilities, so it’s important to talk to an expert for advice on your individual situation. That’s where your Relationship Executive can help. Working closely with specialists across the Commonwealth Bank Group, they can suggest strategies to counter the full spectrum of financial risks.

Risks to your business

Risk Potential impact Probability Solutions

Interest rate risk Medium High FlexiLoan ›

Bill Facility ›

Currency risk Medium High Forward Foreign Exchange ›

Currency Options ›

Flexible Forwards ›

Import and export risks

High Medium International Money Transfer ›

Documentary Letter of Credit ›

Documentary Collection ›

Trade Advance ›

Foreign Bills Negotiated ›

Without Recourse Export Finance ›

Insured Export Finance ›

Trade Finance Facility ›

TradeXchange ›

Risks to people and assets

High Low Key person and succession cover ›

Building, stock and equipment cover ›

Professional indemnity cover ›

Directors and officers liability cover ›

Managing risk | 3

Unless your business is debt free, loan repayments are likely to be a significant part of your cost structure. Which means that adverse interest rate movements can have a real impact on your bottom line.Recent decades have shown how quickly interest rates can move both up and down. And while we’re unlikely to see a return to the 17% cash rates of the early 90s, that uncertainty represents a real risk to your business.

Rising interest rates can squeeze your cash flow by driving up loan repayments at the same time as inflation is likely to be increasing other costs. The risk can be heightened if:

You’re in a capital intensive industry. ›

You manage projects, such as property developments, with significant long-term capital requirements. ›

You’re borrowing to fund ongoing business growth, but you haven’t yet realised all of the benefits of that growth. ›

You’ve borrowed to buy assets, but rising interest rates mean that your repayments have outstripped the income those assets ›generate, so that they no longer pay for themselves.

In situations like these, the extra financial stress of rising interest rates can severely limit your business’ ability to operate effectively. The challenge is to protect yourself from potential rate rises while still taking advantage of a low interest rate environment.

Fixed rates, caps, collars and combos

Fortunately, there are some sophisticated tools that can help you manage the downside risk of fluctuating interest rates and benefit from the upside as well. Here’s an overview:

A fixed rate › . The most straightforward option. While it gives you the absolute certainty of fixed repayments for a fixed period, it also means that you miss out if variable rates dip below the level at which your loan is fixed.

A capped rate › . A variable rate capped at a maximum level for a fixed period. With a capped rate, you know that you will never pay more than the maximum, even if interest rates rise. And you still benefit from the lower, prevailing rate in the meantime.

An interest rate collar › . A collar combines a maximum rate, or cap, with a minimum rate, or floor. So, while you pay a variable interest rate, you know that it will always move in a fixed range. The main advantage of using a collar instead of a cap is that you pay a lower premium to put your protection in place.

A combination strategy › . With the right funding tool, you can combine several strategies in a single facility, known as a combo. For example, by splitting your loan equally between a fixed rate, a capped rate and a variable rate, you can achieve some degree of protection against significant rate rises and reduce the effects of interest rate volatility.

Developing a strategy

Your objectives

Analyse the risk to your business from interest rate fluctuations. ›

Reduce interest rate uncertainty while still gaining the greatest possible advantage from falling rates. ›

Actively manage interest rate settings over time to suit your changing capital requirements. ›

Solutions

FlexiLoan A versatile lending solution that helps you manage interest rate risk. By combining up to 20 individually customised sub-accounts in a single facility, each with its own interest rate and repayment settings, you can use a variety of risk management tools.

Bill Facility An alternative to a bank loan that can be structured as a term loan or a revolving line of credit, with a full range of interest rate risk management options.

Interest rate risk

4 | Managing risk

Managing risk

Case study

Managing interest rate risk

The problem Megalopolis Developments was an established property developer about to begin constructing an eight townhouse complex in Western Sydney. The company needed to borrow $20m for the project, which had three main phases:

1. Construction. This phase would take a year, during which the company would need to make regular progress payments. The payments were structured to occur once a month, but could vary due to weather and the demands of other projects.

2. Marketing. In the second year, the company would market the townhouses.

3. Sales. In the third year, the properties would be sold and the company would repay its loan.

The size and length of the project meant that Megalopolis was exposed to considerable interest rate risk. They asked their Relationship Executive how they could reduce that risk, while managing their borrowings most effectively over the life of the project.

The solution Megalopolis’ Relationship Executive recommended a FlexiLoan, structured to support the company’s changing cash flow:

In the construction phase, Megalopolis would draw down on multiple loan sub accounts as required to make ›their progress payments. The sub-accounts would be split between fixed rate, capped and variable interest rate options, reducing overall interest rate volatility and providing them with partial protection against any interest rate rises.

In both the construction and marketing phases, the company would make repayments of interest only, ›keeping cash flow pressure to a minimum.

In the sales phase, the capped and fixed rate sub-accounts would convert to standard variable accounts, ›giving the company flexibility in repaying their loan. In this phase, the company would pay down their loan with bulk repayments as each townhouse was sold and settlement took place.

The result While interest rates were relatively low at the time the project began, they rose and fell significantly during its three year life. But Megalopolis’ fixed rate and capped rate accounts helped to protect them against the rises, while their capped and variable accounts allowed them to benefit from later falls. Most importantly, their combination strategy reduced overall interest rate volatility, helping to make their cash flow more predictable.

At the same time, Megalopolis’ FlexiLoan gave them the flexibility they needed for each phase of the project – drawing down gradually on their facility in the construction phase, making interest only payments in the marketing phase, and making bulk repayments in the sales phase.

Interest rate risk (cont.)

Managing risk | 5

First quarter

Capped rate

Variable bill rate

Rate paid by Megalopolis

Second quarter Third quarter Fourth quarter

5.50%

6.00%

6.50%

7.00%

7.50%

8.00%

By using a capped rate, Megalopolis took advantage of the low interest rate environment while protecting themselves against later rate rises.

This is a hypothetical example for illustrative purposes only and uses rates and figures selected by Commonwealth Bank to illustrate how this strategy works. The example should not be taken as personal advice or an indication of actual or future prices that may apply. It is not a recommendation to you and should not be regarded as an accurate statement of affairs concerning any particular product. It does not represent any particular individual or company.

Variable bill rate

Capped rate

Rate paid by Megalopolis

6 | Managing risk

Managing risk

It isn’t only importers and exporters who are exposed to currency fluctuations. If you source stock or equipment offshore, then currency risk should be on your radar.Much of Australia’s economic strength is a result of our success as a trading nation, particularly as an exporter of raw materials. But that also has its pitfalls.

The Australian dollar is widely seen as a commodity-based currency. As commodity prices fluctuate, so does the dollar. As a result, the Australian dollar is one of the world’s more volatile currencies.

That has practical implications for you and your business. For example, imagine that you had imported a piece of equipment costing US$100,000 in the second half of 2008. Unless you protected yourself against currency fluctuations, your equipment could have cost anything between AU$102,187 and AU$163,345, depending on the timing of your transaction.

Currency risk

July 2008 August 2008 September 2008 October 2008 November 2008 December 2008$100,000

$110,000

$120,000

$130,000

$140,000

$150,000

$160,000

$170,000

The changing cost in Australian dollars of a US$100,000 equipment purchase.

Source: Exchange rate data sourced from the RBA website.

Managing risk | 7

Developing a strategy

Your objectives

Analyse and quantify currency risk in your business. ›

Protect your business from the negative impact of exchange rate fluctuations, at the lowest possible cost. ›

Balance risk and return, allowing your business to capitalise on any opportunities for gains from exchange rate volatility. ›

Avoid relying on timing transactions. Currency movements are unpredictable, and even professional currency traders can ›be caught out.

Solutions

Forward Foreign Exchange

A contract that allows you to lock in an exchange rate for a specific date. Forward Foreign Exchange allows you to plan with certainty, even if a transaction isn’t due to be settled until a future date.

Currency Options Gives you the right, but not the obligation, to exchange at a specified rate on a specified date.

Flexible Forwards Flexible Forwards combine the security of a Forward Exchange Contract and the flexibility of a Currency Option. With flexible forwards, you can protect your business against adverse exchange rate movements, while still benefiting if the exchange rate moves in your favour.

8 | Managing risk

Managing risk

Trading overseas can help you tap into thousands of potential new customers, and find new and more cost-effective suppliers and manufacturers. However, it also comes with some specific risks of its own.Currency fluctuations are just one of the risks facing importers and exporters. Doing business with customers and suppliers overseas has its own specific challenges.

While there are well-developed procedures for handling the complexities of moving goods and making payments across international borders, there’s also a lot that can go wrong. Leaving aside the risk of deliberate fraud, problems with transport and customs can leave you out of pocket – especially if you’ve already invested time and money in stock, suppliers and manufacturing.

Choosing a payment method

The payment method you choose can have a significant impact both on your cash flow and on your level of risk. It determines how soon you pay (if you’re importing) or get paid (if you’re exporting). It also determines who runs the risk that the goods or the money won’t be delivered as scheduled – the buyer or the seller.

Seller more secure Buyer more secure

Payment method Payment in advance Documentary Letter of Credit

Documentary collection Payment when goods received

If you’re selling You’re completely secure. You don’t send the goods until you’re paid.

The buyer’s bank conditionally guarantees that you’ll be paid when they get compliant shipping documents and other paperwork specified in the credit.

Your bank sends paperwork to the buyer’s bank, and chases payment for you. You keep control of the goods until the buyer pays or accepts the documents.

You don’t get paid until the buyer gets the goods. You must trust the buyer.

If you’re buying You pay first, then the seller despatches the goods. You must trust the seller.

Your bank conditionally guarantees to pay the seller when they receive compliant shipping documents and other paperwork specified in the credit.

The seller’s bank sends paperwork to your bank. Your bank releases the shipping documents and other paperwork to you when you pay or accept the documents.

You’re completely secure. You don’t pay until you get the goods.

Seller paid sooner Seller paid later

Your payment method determines your level of risk.

Import and export risks

Managing risk | 9

Trade finance

Trading offshore can stretch your finances to the limit, simply because of the time it takes to complete the cash flow cycle. If you’re an importer, you know it takes time to order and transport stock, clear it through customs, and get it into the hands of customers. For exporters it can be even worse, with months passing between the time you start production and the time you get paid by your overseas customer. The result can be a sizeable cash flow gap.

Developing a strategy

Your objectives

Exporters

Receive payment as soon as possible (preferably before manufacture and shipment). ›

Retain control over the goods until you have been paid. ›

Finance the cash flow gap between investing in manufacture or stock purchases and being paid by your overseas customers. ›

Reduce the risk of fraudulent buyers, bad debtors or trading in unfamiliar markets. ›

Importers

Defer payment as long as possible. ›

Receive and examine the goods before paying your supplier. ›

Finance the cash flow gap between paying your overseas suppliers and being paid by your local customers. ›

Reduce the risk of fraudulent suppliers or trading in unfamiliar markets. ›

Solutions

Payment methods

Documentary Letters of Credit

Documentary Letters of Credit involve trusted parties at both ends of the transaction – the buyer’s and seller’s banks. That makes them suitable for:

Importers › who want a high level of risk mitigation when buying goods from overseas suppliers. You specify which documents you need to receive under the Credit, then pay, or agree to pay, only when compliant documents are presented to your bank. Can be linked with a Trade Advance to create an import loan financing solution.

Exporters › looking for risk mitigation when dealing with unfamiliar buyers or higher-risk countries. You can mitigate risk further by linking your Documentary Letter of Credit to a Letter of Credit Confirmation, or create an export financing solution by linking it to Without Recourse Export Finance.

Export Documentary Letters of Credit Confirmation

For exporters who are looking for the highest level of risk mitigation and protection when dealing with unfamiliar buyers or higher-risk countries. With a Letter of Credit Confirmation, we guarantee to pay you, the Exporter, if you present the compliant documents called for under the Credit. That protects you from the risks of dealing with an overseas buyer, an overseas bank and an overseas transfer system. Financing options are available when linked to Without Recourse Export Finance.

Documentary Collections

Like Documentary Letters of Credit, Document Collections involve the buyer’s and seller’s banks, so that both sides of the transaction are represented by a trusted party. They suit:

Importers › who want a slightly higher level of risk mitigation than they would have when dealing on Open Account or making a payment in advance via an International Money Transfer. You only pay (or agree to pay) when your bank receives documents. Can be linked with Trade Advances to extend your payment periods.

Exporters › who want a slightly higher level of risk mitigation than they would have when dealing on Open Account or agreeing to receive payment on receipt of goods at the buyer’s end. Documents will not be released to the buyer until they have paid or agreed to pay. Can be linked with Foreign Bills Negotiated to provide financing in advance.

10 | Managing risk

Managing risk

Trade Finance

Trade Advance Short term finance to close the cash flow gap for a particular transaction.

Foreign Bills Negotiated

Designed for exporters who use Documentary Collections, Foreign Bills Negotiated gives you finance when the goods are shipped, so you effectively get paid as soon as you ship the goods.

Without Recourse Export Finance

Designed for exporters who use Documentary Letters of Credits, Without Recourse Export Finance can provide risk cover on the buyer’s bank and country (in the form of a Letter of Credit Confirmation) and give you the option of guaranteed payment as soon as the conditions of the Documentary Letter of Credit are met. We pay you, then seek repayment from the buyer’s bank – so your risks are reduced and you get paid sooner. Because the payment is without recourse, the liability no longer remains on your balance sheet.

Insured Export Finance

Designed for exporters who hold credit insurance on their overseas buyers, Insured Export Finance helps you get paid sooner and reduces the risk that your overseas buyers don’t pay.

Trade Finance Facility

A Trade Finance Facility allows you to draw on a combination of the options listed above within your umbrella limit. You choose the option that suits you for each transaction, then tailor the amount, currency and payment method.

TradeXchange TradeXchange is an easy-to-use online trade finance management tool, available through CommBiz for approved clients. It enables you to create, view and manage Documentary Credits and Documentary Collections at the click of a mouse, 24 hours a day.

Case study

Managing import and export risks

The problem Tenterfield Designs was a manufacturer and wholesaler of distinctive Australian designer furniture. Tenterfield’s pieces were designed in Australia, manufactured in China, then exported to the US and Europe, as well as being sold in Australia.

After enjoying rapid growth, Tenterfield began to encounter problems. A new supplier failed to deliver after being paid an advance, while an overseas distributor failed to pay for a shipment of furniture that had already arrived in their home port. At the same time, Tenterfield was increasingly exposed to currency risk as their business grew, since their contracts with suppliers and distributors were denominated in either US dollars or Euros.

The solution Tenterfield consulted their Commonwealth Bank Relationship Executive, who set up a consultation with a trade finance specialist. Together, they created a risk management plan that included:

Ongoing currency hedging for each offshore transaction, using Currency Options. ›

Documentary Collections for purchases from established, regular overseas suppliers. ›

Documentary Letters of Credits for sales to overseas distributors. ›

Without Recourse Export Finance to accelerate payments and fund the cash flow gaps along the value chain – ›from beginning manufacture to receiving payment from offshore clients.

The result Because Tenterfield was effectively both an importer and an exporter, foreign exchange fluctuations represented both a risk and an opportunity. By covering each transaction with Currency Options, which gave them the option of exchanging at a specified rate if it was advantageous to do so, they protected themselves from the risks while taking advantage of the opportunities.

Using Documentary Collections for overseas purchases gave Tenterfield the security of deferring payment until their bank had received documents indicating that the goods had been shipped. Using Documentary Letters of Credit for exports meant that they could be confident they would be paid after shipping the goods and presenting compliant documents to the Bank. It also allowed them to take advantage of Without Recourse Export Finance, bringing forward payment and reducing the risk of bad debts.

This is a hypothetical example for illustrative purposes only. It does not represent any particular individual or company.

Import and export risks (cont.)

Managing risk | 11

Your people and key assets are essential to your ability to generate profits now and in the future. Protecting them is an integral part of any risk management plan.

Protecting key people

It’s a familiar paradox. While most business owners routinely insure assets like vehicles, which are of relatively little value, they often ignore the risk of losing their largest generators of wealth – themselves and the other key people in their business.

Depending on the structure and size of your business, the death or disablement of a key person may lead to a loss in revenue, impair your cash flow position and potentially raise the issue of business succession arrangements.

Protecting assets

Then there are the other key assets that are crucial to the day-to-day operation of your business, such as buildings, plant and equipment. While disasters like floods and fires are relatively rare, their potentially catastrophic impact makes it essential to guard against them, especially since it can be achieved for a relatively low cost.

Unfortunately, while most businesses begin with adequate insurance cover, it’s all too common for a growing asset base to outpace your level of cover, leaving you under-insured. That’s why it’s important to actively review and manage your insurance portfolio as your circumstances change.

Developing a strategy

Your objectives

In the event of the premature death or disablement of a principal or key person, protect your business against: ›

The loss of profits, and the subsequent effects this loss has on your cash flow and ability to service outstanding commitments.•

The cost of liabilities, such as loans and entitlements, which could be owed to the estate of a deceased director.•

Business succession issues when an owner dies or is incapacitated, leaving their interest in the business to beneficiaries who •you may wish to buy out.

Protect your business against actions from unsatisfied customers. ›

Insure yourself and the other business owners against risks to your personal finances from your role in the business. ›

Identify and protect key physical assets of your business. ›

Ensure your insurance portfolio remains adequate to the changing needs of your business. ›

Risks to people and assets

12 | Managing risk

Managing risk

Risks to people and assets (cont.)

Solutions

Key Person Cover and Business Succession

By providing insurance benefits in the event of the death or disability of a key person, the CommInsure Personal Insurance Portfolio can help your business meet its ongoing commitments and repay debts. It could also potentially fund the purchase of shares in the business owned by a business owner who is deceased or has become seriously incapacitated.

Building, Stock and Equipment Cover

By insuring buildings, stock and equipment, you can cover the replacement cost of damaged or destroyed assets, ensuring business continuity and protecting yourself against some of the profits you would forgo if a disaster occurred.

Professional Indemnity Cover

Professional Indemnity Cover protects your business against claims by dissatisfied clients, including claims of negligence, intellectual property infringement, disclosure of confidential information, loss of data or documents, and dishonesty by your employees.

Directors and Officers Liability Cover

Increasingly, company directors and officers are being held personally liable for activities undertaken during the course of their duties. Directors and Officers Liability Cover can protect you from the potentially devastating effects on your personal finances.

Managing risk | 13

Talk to us

Every business is different. You face a unique set of risks and opportunities which will change as your business grows and develops. So it’s important to talk to an expert.

Your Relationship Executive can help you explore the risks confronting your business and develop a tailored plan for your individual circumstances. Working closely with specialists across the Commonwealth Bank Group, they can identify your exposure to different kinds of risk, quantify their potential impact, and create cost-effective solutions that allow you to plan with greater certainty.

They are supported by product and industry experts who understand the pressures on your business and can provide insights into market conditions and industry trends. Ask your Relationship Executive about the wide range of Commonwealth Research available to help you stay up-to-date on the latest economic data affecting your business and the wider economy.

To find out more about managing risk:

Call your Relationship Executive ›

Visit › commbank.com.au/corporate

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