Strategic Risk vs Financial Risk: Where Each One Bites

A financial risk changes what a business owes. A strategic risk changes what a business is. One small manufacturer published both in a single year, and each one hides in the place the other shows itself. The strategic exposure lands as an exact amount in the profit and loss with nothing recorded about its cause. The financial exposure is nearly invisible on the balance sheet and names itself in the interest line.

Two figures off one set of accounts, and they disagree by more than three times. Which one is wrong?

Anjani Stationers Private Limited, a made-up business, prints two numbers about the money it borrows. On its reporting dateThe single calendar day a balance sheet describes. In India that day is usually 31 March, and every balance on the statement is that one day's reading. it carries gross borrowingsEverything a business owes to lenders on a given day, added together, before anything at all is taken off the total. of Rs 10,20,000/-. Across the same twelve months, the same three sources averaged Rs 37,00,000/-.

Put those side by side and something feels broken. Neither figure is wrong, nobody made an error, and nothing was concealed: the year carried about three and a half times what the reporting date recorded, and both readings are published. A balance is a reading taken on one day. An average is a reading taken across every day. Both readings share a unit and are not the same quantity. The money in a household current account on the afternoon the salary lands is not the money in that account averaged across the month. Nobody would call the payday reading a lie. The reading was simply taken on the wrong day for the question being asked.

No lender withdrew anything. No facility was called in. No agreement was broken and nothing failed. The exposure is published in full, sitting in the ordinary accounts of an ordinary trade, and that is the whole of it.

So which question separates them, if a list of risk types does not?

A taxonomy is the natural thing to reach for: two boxes, a definition in each, and a rule for sorting things between them. A taxonomy does not survive the borrowing above. Two correct figures about the same borrowing on the same business disagreed by a factor of three and a half, and no taxonomy of risk types separates those two figures. The two figures belong to the same risk, and differ only in the span over which somebody measured them.

Two questions do the work instead, asked strictly in that order. The first question is which statement would show it and over what span, and the second question is what that statement withholds, being a size or a cause. Neither question requires agreement on a label, and both of them have answers that can be checked.

The order carries the whole argument. Asking what kind of risk something is starts an argument about words, in which two careful people can reach different answers and neither can produce evidence. Asking which statement would show it names a document and a period, and a document either carries a line or does not. Naming the instrument is checkable, and naming the category is a matter of taste. The two questions buy different things: the first says where to go and look, and the second says what will still be missing once the looking is done.

What does the financial side actually look like when it is published?

One table carries the rest of the argument. Three sources, three columns: what each one read on the reporting date, what each one averaged across the year, and what each one cost in interest.

A table that has been checked is a different object from a table that has merely been shown, and the column adds up before the reading begins. The three interest figures come to Rs 3,50,000/- exactly. The three reporting-date balances come to Rs 10,20,000/- exactly, with the facility contributing nothing. The three averages come to Rs 37,00,000/- exactly. The table closes in all three directions, so there is no fourth component hiding anywhere, for the plain reason that there is no fourth instrument.

The shape of that facility across the twelve months is also published. Anjani Stationers prints exercise books and registers for schools, so its buying happens before the school session begins and its money comes back afterwards. The facility runs up toward Rs 45,00,000/- in the weeks when paper is being bought and registers are being made against orders nobody has yet paid for, and it is back to nil by the time the reporting date arrives. A stallholder who borrows to stock up before a festival and clears the loan before the shutters come down has the same shape, and nobody thinks worse of them for it.

Three quarters of the interest was paid on a line reading nil. How does that happen?

Take the two marked cells out of the table and set them against each other. The year's finance costThe line in the profit and loss holding what borrowing cost the business over the whole period, which is mostly interest. is Rs 3,50,000/-, and Rs 2,64,000/- of it was charged on the cash credit facility. In the words of the notes where this is already printed, the facility that appears on the balance sheet at nil generated about three quarters of the year's interest.

Do the impossible arithmetic first. The contradiction is more useful felt than explained. Interest is charged on money actually drawn. A charge of Rs 2,64,000/- therefore requires drawn money to charge it on. The balance says the drawn money is nothing. Both statements are published, both are correct, and on the face of it they cannot both be true.

The resolution is the span, and only the span. The balance covers one day and the interest covers every day in the year, so the two are never describing the same period and were never in conflict. The interest line is the only place on the face of these accounts where the year's real borrowing leaves a mark at all. Nothing else on either statement records that Rs 26,40,000/- was out on average, or that the facility ran up toward Rs 45,00,000/- before the session. Take the interest line away and that borrowing becomes, as far as any published document is concerned, something that never happened.

What did the year's availability cost, and where does that price sit?

There is a second reading in the same cell, and it sharpens the point rather than repeating it. The Rs 2,64,000/- is not one charge. The amount is Rs 2,50,800/- of interest on money actually drawn, worked at the 9.5 per cent this business states in its own terms, plus a commitment feeA small charge for keeping a borrowing line open and available. The fee is payable whether or not any money is drawn in a given month. of Rs 13,200/-. Put the whole price over the average drawing of Rs 26,40,000/- and the effective cost comes out at 10.0 per cent, against a stated 9.5.

The fee buys the right to draw rather than the drawing itself, so part of what this facility cost was paid for something that never appears as a balance on any day of the year. A household paying a small standing charge on a connection it barely used this month knows the feeling exactly: the bill arrives, the usage column reads almost nothing, and the total is still not zero. Neither rate is wrong. The stated one describes what money costs when it is drawn, and the effective one describes what the arrangement costs when it is kept available.

One inclusion list, and the sign changes. So which answer is right?

The financial side has a second half, and it is not arithmetic at all. The second half is a decision about what to count. Anjani Stationers holds cash of Rs 5,00,000/- on the same reporting date. Set that against gross borrowings of Rs 10,20,000/- and net debtGross borrowings less the cash a business holds. Where the cash is the larger of the two, the answer comes out the other way round and is called net cash. is Rs 5,20,000/-. Net debt of Rs 5,20,000/- is a real answer, and a reasonable person would write it down.

Now take the lease liability out of the list. Plenty of careful readers do, on the grounds that a rental commitment is a different animal from money a lender handed over. Gross borrowings become Rs 4,20,000/-, the cash is unchanged at Rs 5,00,000/-, and the same balance sheet on the same day now gives net cash of Rs 80,000/-. One defensible choice about one line takes the same business on the same day from owing money to holding it.

Neither answer is wrong. The discomfort of that is exactly the part worth keeping. A net figure that arrives on its own has left behind the decision that settled its sign, so the inclusion list has to travel with the figure, as a working rule rather than a preference. Two people counting the same household's debts, one of them counting the rent commitment and one of them not, will disagree about whether that household is in the black, and both will be adding correctly. How much a business decides to count and how far it lets a number move before somebody has to act is a separate subject, covered under Risk Appetite, Tolerance, Capacity and Limits.

What does the profit and loss show, and what does it refuse to say?

Same business, same year, other statement. The standing costA cost that stays the same whether the business makes a lot or a little in a period, such as rent or a monthly salary. base ended the year at Rs 74,00,000/- against Rs 49,60,000/- the year before, up by Rs 24,40,000/-. Contribution ended at Rs 1,15,50,000/- against Rs 1,02,60,000/-, up by Rs 12,90,000/-. Operating profit went the other way, ending at Rs 41,50,000/- against Rs 53,00,000/-, down by Rs 11,50,000/-. Now set the two rises against each other. Take the extra standing cost of Rs 24,40,000/- away from the extra contribution of Rs 12,90,000/-, and what remains is precisely the Rs 11,50,000/- that came off the profit. Nothing at all is left spare when the movement closes, and that is what turns it into evidence instead of a tale somebody told about a hard year.

The new base works out at 27.41 per cent of revenue, so more than a quarter of everything arriving at the door now stands still whatever sales do. Contribution divided by operating profit shifted from 1.94 to 2.78 across the two years. The shift rests on a split between the cost that moves and the cost that stands still which the notes publishing it label an estimate and not a disclosure: materials, together with a Rs 6,00,000/- portion of other operating costs handled as though it varied, over a Rs 74,00,000/- base those same notes expect to fall away once the one-off cost of buying into the binding operation washes out. The label goes wherever that multiple goes, here and in every place further down.

Now the withholding, an exact mirror of what happened on the borrowing side. Where did the Rs 24,40,000/- go? Three items get named. People. Space. And buying into a binding operation. Not one of the three carries an amount anywhere at all. Three things are named and none is priced, so the accounts show the size of this exposure to the rupee and contain no field at all for its cause. Treat that as normal rather than as a lapse: no lodging regime requires that breakdown, and hardly any business hands it over unasked.

One amount does sit beside the binding operation, and it lives in a wholly different statement. Chitra Binding Works Private Limited, also invented, was taken to a seventy per cent holding for Rs 21,00,000/-, with an Rs 8,00,000/- guarantee disclosed rather than recognised. Money paid to acquire a holding is an investing payment. A cost base that stands still is an operating cost. Different statements, different questions, and neither amount is a portion of the other. Reaching across to net one off the other would manufacture the very breakdown these accounts decline to give.

So what is the finding, on one business in one year?

The financial risk shows its cause and hides its size. The strategic risk shows its size and hides its cause. The finding has two published halves behind it, and each half is worth earning rather than asserting.

On the borrowing side, the cause is identified down to the last detail. The interest line names the instrument, the rate the business states, and the fee it pays for availability. The amount borrowed, the terms and the kind of arrangement can all be stated precisely. The size cannot be stated. The reporting date reads Rs 10,20,000/- with the facility at nothing, and the Rs 37,00,000/- the year actually carried appears on no statement anywhere. The cause is fully specified and the size is missing.

On the profit and loss side, everything is the other way round. The size is exact to the rupee at Rs 24,40,000/-, and the fall in operating profit closes at Rs 11,50,000/- with nothing unexplained. The cause cannot be stated. Three things are named, none of them carries an amount, and no arithmetic anywhere connects them to the total. The size is fully specified and the cause is missing.

Which gives a working habit rather than a definition. Where the cause can be named, the size is the thing to go and check, and where the size can be seen, the cause is the thing to go and ask for. Think of two households: one that knows exactly what it spent last year and not what on, next to one that knows exactly what it borrowed for and not how much it owed at the worst moment. Both are holding half a picture, and neither of them is lying to anybody.

Can one decision be both at once?

One decision already worked through sits on both sides at once. Adding people, space and a binding operation was a commitment about the shape this business would take from then on, and a commitment of that sort sits squarely on the strategic side. The same commitment lifted the standing base, and the standing base lifted the multiple from 1.94 to 2.78, on that same split, which its own notes label an estimate and not a disclosure. Lifting the multiple is not a metaphor: it changes how hard any movement in revenue lands when one arrives.

The arithmetic is published, so the size of that change is visible without estimating anything. Revenue down 10.00 per cent takes this business from Rs 41,50,000/- of operating profit to Rs 29,95,000/-, a fall of 27.83 per cent. The fall is the multiple times the movement and nothing else. One movement in, one landing out, and nobody had to put a number on how likely the movement was to learn it. Amplification is not obligation.

Nobody is owed anything here. Nothing is repayable, no counterparty exists, and no date falls due, so on the test the borrowing table was built on this is not a financial risk at all. And yet the commitment changes what a poor year does to the profit, and that change is very close to what most people mean when they say they are worried about a business's financial risk. The two categories are about where to look rather than about what happened, and the same decision can be read on both instruments.

Two neighbouring questions have their own homes. Testing a commitment of that sort before any money moves is set out under How to Evaluate a Strategic Initiative Before It Is Taken. Setting either exposure down in ordered rows, so somebody can work through them one at a time, is set out under The Business Risk Register: Recording What Could Go Wrong.