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Managing financial risk: a quick guide for apparel businesses large and small

November 4, 2020

Interest in financial risk has grown across the apparel industry in the wake of the COVID-19 pandemic – a report by Better Buying found that 70% of suppliers reported cancelled orders from customers and 66% saw existing order sizes shrink as the impact began to be felt. How to protect against losses and make better, more informed financial decisions have become pressing priorities for apparel companies the world over.


What follows is a simple breakdown of what financial risk is, why risk management is an imperative for apparel businesses large and small, and the steps they can take to boost the resilience of their companies.  


What is financial risk?

Financial risk describes the exposure of a business to losing money in one form or another. It is a core risk area and can be broken down into four key types:


Market risk

Originating in the market or external environment, market risks are relative to the context in which your business is operating and constantly evolving. They require regular monitoring to minimise surprises and remain adaptable. Sources of this type of risk include changes to relevant trade policies, interest rate shifts, the rise of geopolitical tensions, disruptions to the competitive landscape and the occurrence of natural disasters.


Credit risk

As the apparel industry relies on credit for a variety of purposes, credit risk is the possibility of financial loss due to a breach of contract between parties. Since the beginning of the pandemic, Better Buying found that 41% of suppliers had reported an extension to payment terms and 35% were seeing an increasing number of late payments. Ways to hedge against credit risk include requiring advanced payments to better secure accounts receivables and obtaining trade credit insurance in the case of non-payment. Acquiring business reports that detail the legal, economic and financial health of your current or prospective clients is also a viable way to minimise credit risk.


Liquidity risk

In a context of rapid digitalisation, liquidity risk is an important area of focus for many apparel suppliers who may be trying to raise funds to upgrade their technological capabilities or sell assets that have become unproductive. Keeping cash reserves and ensuring the ability to liquify assets should the need arise are necessary to minimise liquidity risks. Methods like receivables financing and invoice factoring can help in this regard, as well as staying aware of changes to interest and exchange rates.  


Operational risk

Day-to-day business activity is the source of operational risk. There are risks stemming from illegal activity like theft and fraud as well as those deriving from poor budgeting practices and unrealistic financial projections. Managing these risks well can minimise otherwise avoidable hits to the bottom line and keep finances flowing to the value-adding and revenue-generating areas of your business.


How to think about financial risk management

The areas of financial risk described above may seem like a lot to manage, but there are a couple important points to make in this regard. First, it is necessary to take a long-term view. Risk management is about maintaining business continuity over time and is therefore in the interest of all apparel businesses. Having a sober view of how financial risk relates to your decision making and business objectives is key – for being both too reckless and too conservative can work against your competitiveness in the market.


Second, is the issue of investment. There is a tendency to think that risk management is the prerogative of large-scale apparel companies with ample resources. But the reality is that it is accessible to businesses both large and small, especially today with the proliferation of digital risk management solution providers. The key is having the right approach for your business, which does not necessarily require large amounts of time, labour or capital. Investing a bit upfront to develop a budget and a practical framework for allocating resources in accordance with your risk priorities can go a long way toward protecting your business from unnecessary expenditures or losses down the line.  


How to conduct financial risk management

Financial risk management, like all other forms of risk, involves two aspects. The first is understanding the financial risks relevant to your business. The second is setting out a plan to manage them against your risk appetite over time. The method of financial risk management includes four pillars:


Identification

The process of identifying financial risks is step one and crucially important to get right. Where is your business vulnerable to losses? It is important to look everywhere to obtain the clearest possible understanding of where you are most and least at risk. Also to note is that the ‘identify’ phase of financial risk management is not a one-off exercise. It works best when done regularly, as a way of keeping a pulse on the changing environment and dynamics affecting your business.


Assessment

Because your business can never eliminate or completely absolve itself from confronting financial risk, it is necessary to determine your risk appetite. For each risk identified, analysis is required to determine whether it should be accepted or avoided or what its materialisation may mean for other risks arising. One method is risk scenario analysis, which is employed to analyse chains of events and their root causes – for example, how the risk of damaged infrastructure can trigger associated risks like hazardous working conditions and production delays. It can help apparel manufacturers prioritise the risks that would be most damaging if they materialised and take action to mitigate them.


Framework development

After the ‘identify’ and ‘measure’ phases comes the development of a framework for the day-to-day management of financial risks. This involves exercises like establishing so-called ‘lines of defence’ - from the frontline managers and personnel responsible for implementing your risk management policies to higher-level bodies in charge of developing and guiding your risk- and compliance-related directives.


Maintenance

The key to successful financial risk management is doing it over time. This requires a commitment and a process for regularly revisiting each phase to stay informed of the financial risks facing your company, assessing them against your risk appetite and planning out their management. It also requires auditing of the entire financial risk management process from time-to-time to identify areas in need of improvement.


If you’re interested in learning more about risk management and other topics related to the apparel industry, keep an eye on the Serai newsfeed.


Sources: Better Buying, Ibid, The Institute of Internal Auditors.