MANAGING NET INCOME LOSS EXPOSURES
MANAGING NET INCOME LOSS EXPOSURES
Back in December of last year, I woke up one morning to find that I had no water because of a water main break. Without H2O it really limits your activities, you cannot shower, flush toilets, cook or get a drink of water. My water cooler in the kitchen was empty and I had forgot to fill up the water jug in the fridge. The only water I had was about 2 litres in a 4 litre bottle I use for working out. As a risk manager I had backup systems but failed to maintain them.
I decided to go out to try and get some water and was surprised to find that the grocery stores in my area were open but the restaurants and many other businesses were closed. It seems we are totally unprepared to deal with an interruption let alone a catastrophic event. While most organizations can survive a couple of days in a crisis, what would happen in an extended period of partial or a full shutdown? This got me thinking about how organizations can prepare for and manage net income loss exposures.
There are so many things going on right now in the world, we have the war in the Ukraine, Covid 19, Inflation at levels not seen in forty years, record low interest rates that are increasing, record high consumer, business and government debt levels, supply chain shocks with transportation bottle necks, lack of raw materials and finished goods, labor shortages, high oil and gas prices and the list goes on. The automobile business has been affected by a shortage of microchips and as a result there has been a substantial decrease in auto sales. It shows how the Just in Time inventory management system is risky if the risk management system does not predict and plan for high impact and low probability events such as microchip shortages.
With everything going on in the world I think Vladimir Lenin said it best “There are decades where nothing happens; and there are weeks where decades happen.”
Net Income Loss Exposures are unexpected reductions in an organizations net income, usually because of a decrease in sales or an increase in expenses. Net income could be lower than projected because of the business environment or an inadvertent event, such as a hurricane or pandemic such as Covid 19. Of course net income could also unexpectedly increase, which would be a good thing.
There are three types of Net Income Loss Exposures, Property, Liability and Personnel.
Property Loss Exposures: are damage to the organizations property that hinders or prevents the organization from operating. Such as a manufacturing plant fire that shuts down manufacturing or severally reduces the production output. It could also be damage to property owned by others such as an environmental hazard.
Liability Loss Exposures: are financial losses that result from legal action taken by someone who is claiming damages and looking for financial compensation. Examples could include product liability or negligence resulting in bodily injury.
Personnel Loss Exposures: are losses suffered through the resignation, death, disability or retirement of a key employee. Such as the death of a software engineer developing a new program or the resignation of your top salesperson who moves to your competitor.
If we consider my examples above about things going on in the world, they would reflect general business risk. Which could reduce net income or increase expenses, by creating price risk or production risk. So for this article we will focus on just General Business Risks.
The impact a Business Loss Exposure has on your organization depends on a number of factors;
1. The Duration of the Business Interruption: This is one of the most important determining factors, the longer it goes on then the greater net income decreases or the additional expenses continues to increase.
2. The Extent of the Business Interruption: While the duration deals with timeframe, the extent deals with the overall impact on the organization. Can you continue at a reduced capacity or are you totally shut down?
3. Changes in Revenues: This can be calculated based on the decline in sales and/or the net income changes.
4. Changes in Expenses: How much does the Business Loss Exposure increase expenses such as the cost of raw materials and labor?
5. Restoration to Normal Income: How long will it take to get back lost customers or restore the organizations damaged reputation? This simply means to restore net income to where it would have been if the event did not occur.
Drawing on the list I mentioned earlier of events going on in the world, we will separate them into General Business Risk and Specific Business Risk. General Business Risk affects all firms in the economy while Specific Business Risk affects one firm or a group of similar firms.
GENERAL BUSINESS RISKS:
INCREASING INTEREST RATES: How does this affect your organization? Many organizations were forced to take on additional debt to get through the Covid Pandemic. What affect will increasing interest rates have on your Net Income? For every one percent increase in interest rates your payment will increase by approximately five to ten percent depending on the amortization term. Now is the time to pay down debt or lock in lower interest rates.
INFLATION: Inflation is running around seven percent right now, some experts believe it is a lot higher. The biggest affect inflation has on businesses is that it reduces both business and consumer purchasing power. This will reduce consumer demand for goods and services and increase the cost of raw materials and labour in your business. Can you pass the price increases on to your customers?
RECESSION: Nobody knows what will happen in the economy, but there is a risk that with everything going on there could be an economic slowdown. How would this affect your net income if sales dropped by 10, 20 or 30 percent? The financial industry does stress testing and develops scenarios of events to determine the likelihood of an event occurring and the impact on their business. What is your Break Even Point and how can it be lowered without impacting your firm’s ability to fully operate?
SPECIFIC BUSINESS RISKS:
SUPPLY CHAIN DISRUPTIONS: I just read on Reuters News that in England there is a cucumber shortage, because of the high prices of natural gas the greenhouses could not afford to grow them. This illustrates the cause and effect relationship between increasing gas prices and growing cucumbers out of season. Supply chain disruptions are unique to every organization and need to be identified and managed.
CREDIT RISK: Many organizations extend credit to customers when they purchase their goods or services. If that company cannot repay the money then your organization has suffered a loss. By not being able to collect on your accounts receivable, this creates a net income loss.
INCREASED EXPENSES: Different events can cause an organizations expenses to increase that may not be able to be passed on to customers. The increased expenses create a net income loss. Such as increased food costs for a restaurant chain or higher labor costs.
INHOUSE ACTIVITIES: Poor or uninformed decisions made by management can affect net income. Such as expansion just before a recession or eliminating or adding a new product or service. Decisions should be based on up to date information.
We have discussed the types of Net Income Loss Exposures, the impact they may have on your business and looked at both General and Specific Business Risks. So what is an action plan that you can get started on for your organization?
Because of Covid 19 over the last two years, many organizations have had a rude awakening when it comes to crisis management and having to deal with Net Income Loss Exposures. The U.S. Department of Labour estimates that forty percent of Businesses do not recover from a disaster. They are referring to all types of Loss Exposures including Property and Liability, so as a reminder we are just focusing on Business Net Income Loss Exposures for this article. So how can an organization prepare for the next crisis or the next phase of the existing crisis?
You need to start by looking at your organization and identify your most important customers, your top suppliers, understand your financial situation and determine how much room you have to maneuver. Ask yourself if we lost our best customer how would that affect our Net Income and how could we mitigate the risk. Then look at your suppliers and do the same thing. Could we find another supplier for the goods or services, what would the difference in price be, is it higher, lower or the same? Will this create liability loss exposures, increase customer service or warranty costs or reduce customer satisfaction with the product or service. Get your managers or division heads involved from finance, production, sales and human resources. Ask them what they think are the greatest Net Income risks facing the organization.
To reduce the impact of Liability Net Income Loss Exposures, you start with having adequate liability insurance coverage to reduce the impact and get back to where you were before the event. Unfortunately, you cannot buy insurance coverage for most Business Related Net Income Loss Exposures. You need to identify the risks and develop risk mitigation strategies to ease the burden. Get all departments involved and if you don’t feel up to the task, hire someone to do it for you. Finally every organization has its own unique Net Income Loss Exposures, so it is imperative to start planning now before it’s too late. Remember having a plan is better than not having any plan.