CSME – Nov 2015 – L2 – Q1a – Risk Management and Corporate Strategy

Explains credit risk management concepts, including exposure, losses, residual risk, and appetite.

Question

The finance director of Basket Company is preparing a proposal to present to the board of directors. He believes that the company is much too cautious in its policy of giving credit to customers. At the moment all customers are given 30 days’ credit. He believes that by increasing its exposure to credit risk, and increasing credit terms to 60 days, the company will achieve an increase in annual sales of up to 20%. He also thinks that some improvements in debt collection procedures will reduce the level of bad debts, although some bad debts cannot be avoided. He thinks that the value of sales where there is a default will fall each year from 2% of sales to 1.8% of sales. He proposes that in order to increase annual sales and profits, the company should be willing to increase its risk appetite and accept the risk of higher bad debts.

Required:

Using this example of managing credit risk, explain and illustrate the meaning of:
i. Exposure to risk
ii. Risk of losses
iii. Residual risk
iv. Risk appetite

Answer

i. Exposure to Risk
Exposure to risk is a situation where an entity may suffer a loss or experience negative consequences due to the occurrence of unfavorable events or adverse changes in the environment.

Example: If the company suffers a higher incidence of bad debts due to an increased credit period, this can lead to a loss of income and profit. Another example is the potential loss of customers if the credit period is deemed too short by clients.

ii. Risk of Losses
Risk of losses represents the probability that adverse events may occur within the organization or its environment, leading to loss of income and, ultimately, profitability.

Example: In this case, if the credit period is extended, the likelihood of bad debt increases, heightening the risk of income and profitability loss.

iii. Residual Risk
Residual risk is the risk that remains after efforts have been made to control or mitigate it.

Example: An example in this case is the remaining risk after the improvement of debt collection processes as recommended by the Finance Director.

iv. Risk Appetite
Risk appetite denotes the level of risk an organization is willing to accept to pursue profit, which varies across organizations.

Example: The company currently grants 30 days of credit, but the Finance Director wants to extend this to 60 days, effectively increasing the company’s risk appetite regarding customer credits.

Tags: Credit Period, Credit risk, Exposure to Risk, Residual Risk, Risk Appetite, Risk of Losses
Level: Level 2

Topic: Risk Management and Corporate Strategy
Series: NOV 2015

Uploader: Kwame Aikins