FIN 440 Week 2 Corporate Risk Management and Credit Risk Example

Hedging the Power Bill and Watching a Shaky Customer: Enterprise Risk Management, an Electricity Contract, an Altman Z-Score and Trade Credit Insurance at a Savannah Cold-Storage Firm

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University of Phoenix

FIN/440: Risk Management and Insurance Planning

Week 2 Assignment

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[Date]

Peach State Cold Storage, its customer and all figures are composites written for a model paper; methods, legal rules and research findings come from the sources listed and are stated generally.

Peach State Cold Storage, the composite warehouse near Savannah, pays its utility roughly $2.4 million annually to keep the compressors running, nearly a tenth of revenue. Its utility rate floats with wholesale power and fuel costs, and last summer's heat wave pushed the bill 30 percent above budget for three months. At the same time, its largest customer, a seafood exporter that stores about $9 million of product and pays about $1.9 million a year in fees, has stretched payments from 30 to 75 days. Neither risk appears on an insurance policy, yet either could cost the company more in a bad year than most of the insured losses measured in Week 1. This paper manages both.

An Enterprise View

Enterprise risk management looks at a firm's risks together rather than department by department, links them to strategy and sets an appetite for each. The owners agreed on three statements of appetite: they will not accept any single event that could reduce annual operating profit by more than half, they will keep cash reserves of at least two months of expenses and they will accept moderate variation in costs but not in customer payments. Each risk is assigned an owner, a measure and a limit, and the risk manager reports quarterly.

Why Hedge at All?

In a frictionless world, shareholders can diversify on their own, and hedging adds no value. Smith and Stulz (1985) explained why it can: hedging can lower expected taxes when tax rates rise with income, reduce the expected costs of financial distress and reduce managers' own risk. Froot et al. (1993) added that hedging preserves internal cash for investment when outside financing is costly. For a private company with concentrated owners and limited borrowing capacity, a large energy spike that drains cash could force it to delay a planned refrigeration upgrade. That is the strongest reason for Peach State to hedge.

Measuring the Power Exposure

Over the past five years, the company's annual power cost has averaged $2.2 million with a standard deviation of about $250,000, and the worst year ran $560,000 over budget. The variable rate passes through wholesale price swings, which are highest in summer when cooling loads peak.

A Fixed-Price Contract

A retail energy supplier offered a three-year fixed price that would set the annual cost at about $2.35 million for current usage, slightly above the five-year average but removing most of the variation. The premium of about $150,000 a year over the average is the price of certainty. Alternatives include fixing the price on part of the load, such as 70 percent, leaving some exposure to falling prices, or buying an option-like cap from the supplier. The company chose to fix 70 percent of its expected load for three years, cutting the standard deviation of power costs by roughly two thirds while keeping some benefit if prices fall.

Scoring the Customer

The seafood exporter publishes financial statements. Altman (1968) developed a model that combines five ratios: working capital, retained earnings and earnings before interest and taxes, each divided by total assets, the market value of equity divided by total liabilities and sales divided by total assets. Using the exporter's latest figures, those ratios are 0.075, 0.125, 0.05, 0.37 and 1.875. Weighted by Altman's coefficients of 1.2, 1.4, 3.3, 0.6 and 1.0, the score is about 2.5, in the gray zone between about 1.8 and 3.0, where the model suggests caution but not imminent failure. The ratios show thin working capital and low profitability, consistent with its slow payments.

What the Score Does Not Say

The Altman model was built from manufacturing companies in the 1940s through 1960s, and seafood exporters face different risks, such as tariffs and catch limits. The score is a warning sign that should lead to more questions: the exporter's bank relationships, recent losses and whether other suppliers are being paid late.

A Right the Company Already Has

Under the Uniform Commercial Code as adopted in Georgia, a warehouse has a lien on stored goods for its storage and handling charges and can, after notice, hold or sell goods to recover unpaid amounts. With $9 million of product in its rooms against about $390,000 owed, Peach State is well secured, provided it does not release goods faster than it is paid. The company changed its practice so that goods leave only when the account is within terms.

Trade Credit Insurance

For customers whose goods turn over quickly, the lien offers less protection. A trade credit insurer quoted coverage of 90 percent of unpaid invoices for insolvency or prolonged default across the company's top 15 customers at about 0.25 percent of insured sales, about $45,000 a year. The policy also provides the insurer's credit monitoring of each customer.

Concentration as a Risk of Its Own

The seafood exporter supplies about 7 percent of revenue, but three customers together supply 38 percent. Losing any one of them would leave refrigerated space empty while fixed costs continue. Concentration risk cannot be hedged with a contract, so the company manages it through its sales strategy, adding smaller customers in pharmaceuticals and specialty foods, whose goods are high in value and whose storage needs are steady. The owners set a target of no customer above 15 percent and the top three below 30 percent.

Limits and Monitoring

The company set a credit limit for each customer tied to its score and payment record, a policy of no new storage for any customer past 60 days without approval from an owner and a cap so that no customer exceeds 15 percent of revenue within three years.

Conclusion

Energy costs and customer credit are risks no property policy covers. A partial fixed-price power contract, justified by the value of protecting internal funds, cuts the swing in a major cost. An Altman score flags the exporter for closer watch, the warehouse lien secures most of what it owes and trade credit insurance and limits protect against customers whose goods move quickly.

References

Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609. https://doi.org/10.1111/j.1540-6261.1968.tb00843.x

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Smith, C. W., & Stulz, R. M. (1985). The determinants of firms' hedging policies. Journal of Financial and Quantitative Analysis, 20(4), 391-405. https://doi.org/10.2307/2330757