How Do Financial Terms Impact an Organizations' Decision Regarding Risk Mitigation?

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Although debt can help companies expand their operations and acquire revenue-generating equipment, entering into financing agreements involves inherent risk. Risk management plans often require senior leaders to evaluate their company’s capital structure to decide whether the continued use of financial leverage is appropriate. The terms of financing agreements directly impact risk analysis and management decision making.

Interest Rate

Interest rates impact the total cost of financing and can vary by multiple basis points from one lender to the next. Although interest on debt can be written off against taxable revenue, a high interest rate can end up causing a business cash flow problems over the long run, especially if interest rates are adjustable based on market conditions. Managers must look at their current ratio, which is a measure of current assets to current liabilities, and working capital reserves to ensure they have enough cash to pay principal and interest on their cumulative debt obligations. Selecting the right rates can mitigate solvency risk for an organization.

Repayment Period

The total number and frequency of debt payments can pose a risk to an organization with low or no cash reserves. If the repayment period is relatively short, such as five to 10 years, the size of the payments may pose a cash flow burden. Monthly or semiannual payments are normal for most types of business loans but can vary given the type of financing sought. Management must carefully evaluate the business's cash position to determine whether or not it has the means to make debt payments within the repayment period.

Payment Amount

Loan payment amounts also impact decision making and risk mitigation plans. Potential payments should be weighed carefully to determine their impact on budgets and working capital reserves. If loan balances and periodic payment amounts are high, it may be problematic for a company to deal with, especially if cash inflows are unstable. Keeping payment amounts to a reasonable level helps to mitigate risk and protect an organization from sudden shifts in revenue streams.

Collateral Requirements

If a loan requires collateral such as property, businesses have to weigh the risk of losing the collateral if they default on their financing agreement. For hard money loans, commercial buildings are common forms of collateral. In these situations, a default could mean that a business will be unable to continue as a going concern. Risk mitigation plans must evaluate the loss of collateral relative to an organization's core operations.