This is generally regarded as best practice, but it is one-dimensional given that no analysis is performed and no metrics are brought back to the board and CFO. More targeted risk methodologies have emerged that are better aligned with the requirements of corporate treasurers.
Two of the most important concepts being discussed are cash flow at risk (CFaR) and earnings at risk (EaR). CFaR is a model that measures possible shortfalls in cash flow due to FX rate fluctuations that could have a knock-on effect on a company’s profit and loss (P&L) and liquidity, while EaR is the value of earnings at risk due to FX rate fluctuations.
The link between CFaR and EaR
For corporates, the earnings statement and cash flow statement are key reports for the board and shareholders. The impact that market risk can have on these financial statements will, in turn, impact shareholder value, thus corporate senior management is particularly concerned with these risks. This is why both CFaR and EaR are important components of corporate risk management.
On the surface, the two methodologies may appear close to being the same. However, the relationship between liquidity and earnings is driven by a variety of factors, including the corporate intercompany structure, the locations the company is participating in and the policy around cash repatriations.