(2) Sources of Financial Risk and Strategies to Minimise Risk

Financial risk is the possibility of experiencing monetary loss of an outcome different from the expected one, due to various factors related to finances and investments.


Non-Payment of Monies

When an overseas buyer fails to pay for goods or services as agreed after incurring the cost of goods and transport.


When a foreign customer orders goods from an Australian business on credit for payment later, it takes time and money for the business to manufacture, process and transit the goods to the other country. The goods may arrive at their destination but money may not be paid on time.

This impacts the Aus business’ cash flow and leaves the business at a financial loss for the transaction as they will need to pay extra cost to transit the product back to Australia or navigate the different legal systems and laws to recover the costs incurred.


Reasons for a foreign customer not paying for goods received:

  • Political instability affecting the buyer’s ability or willingness to accept the goods.

  • Declined economic conditions of the country, or business no longer financially stable.

  • Product took longer than expected and is no longer required.

  • Currency fluctuations - increase in AUD and decrease in foreign currency value leading to the goods becoming more expensive than anticipated.


Documentation

The process used to minimise the risk of non-payment of monies in international businesses.


1) LETTERS OF CREDIT

Document from the importers bank which guarantees payment to the exporter.

The seller receives payment once they have fulfilled the transaction and submitted all required documents as evidence (such as the invoice and transit documents) that match the terms set out in the Letter of Credit.

  • Since the bank is responsible for paying, the seller has strong protection against non-payment, even id the buyer defaults.

  • Involves higher costs and requires strict compliance with all the conditions of the Letter of Credit - typically used in high-value or high-risk transactions.


2) DOCUMENTS AGAINST PAYMENT

Process where the buyer can only receive ownership documents to collect the goods after payment has been made.

The exporter sends the shipping documents to a bank, which then holds them until the buyer makes full payment. The buyer must pay before receiving the documents which are needed to claim the goods from customs.

  • Offers some protection to the seller because the buyer cannot access the goods until payment is made - commonly used when the seller has some level of trust in the buyer and the transaction is considered to carry moderate risk.

  • Simpler and less expensive method of securing payment.

  • No bank guarantee - if the buyer refuses to pay, the seller is still left with the cost of storing, returning, or reselling the goods.


Loss / Damage in Transit

When exporting goods there is a risk of them becoming lost or damaged in transit due to:

  • Large distances for goods to travel

  • Multiple forms of travel used (truck, train, shipping, oceans, air, etc)

  • Passes through multiple hands / custody

  • Natural elements

  • Political unrest, e.g. goods stopped at borders.


Insurance

Sharing a financial risk with a 3rd party - insurance company.

An exporter or importer pays a premium to an insurance company for the service of covering a risk such as non-payment of monies, loss in transit, or loss due to currency fluctuations, etc. The insurance company agree to pay out the agreed amount if the exporter/importer suffers a financial loss due to the agreed scenarios.

If the loss does not occur, the insurance company retains the premium fees paid.

The premium charged depends on the insurance company’s financial risk assessment. A business can reduce its premium charge if they agree to an ‘excess’ charge payable when lodging the claim.

  • Insurance contracts are fully customisable and tailored to cover the specific risks of concern to the business.

  • Can protect the business’ cash flow and allows the business to more safely conduct trade internationally, taking advantage of opportunities in other countries.

  • Premium paid can be expensive if the insurance company deems the risk as high.

  • Insurance policies need to be carefully read to ensure the business is covered for each scenario that they require.

  • Claims are not usually paid out straight away as the insurance company will usually investigate the reasons for the financial loss to ensure it is covered by the policy.


Currency Fluctuations

The rate, degree and frequency of change in the value of a countries currency.

The foreign customer may no longer want the goods as their country’s currency depreciates against the appreciating AUD, making the product too expensive, costing more than predicted.

As the Australian dollar increases in value against foreign currencies, demand reduces as the price becomes too expensive for the purchaser, leading to an increased likelihood of cancelled orders or non-payment of orders.

If AUD depreciates, the business will have to pay more for imported raw materials, which will reduce their profit margins.


Hedging

Using agreed currency values in international financial transactions.

If actual currency values change between the time ordered and the delivery, then the agreed value is used to calculate payment.

FORWARD HEDGING - A binding agreement to exchange a currency at a fixed rate on a future date. Rate and date are fixed, with no flexibility. No upfront costs required.

OPTION HEDGING - gives the buyer the ability (but not obligation) to use a set rate or change the currency value to suit the current market when making the payment.

  • Doesn’t eliminate all risk but adds stability, improves budgeting, and helps business remain competitive in global markets.