Financial risk is an inescapable element of running a business. From spending decisions and funding sources to market forces and geopolitical events, companies are exposed to a variety of financial risks on a regular basis. Financial risk management involves determining what amount and type of risk is acceptable and mitigating the impact of those risks as much as possible. While some risks are out of the company’s control, such as policy changes or economic downturns, they can still be planned for and adapted to in order to keep the company as healthy as possible.
Types of Financial Risk
There are many different types of financial risk. Some of the most common are market, credit, liquidity, and operational risk.
1. Market Risk
This refers to the possibility of changing conditions in a market that a company is participating in, whether it be a market in which the business sells products or services, or a financial market that it may be invested in. A new competitor may enter the market, there may be a superior product offering, consumers may choose to leave one market in favor of another (such as the movement to online shopping or offshore manufacturing). A stock price may rise or fall, or a financial asset may lose value.
These changing market situations are typically beyond a business’s control, and it becomes necessary to make contingency plans and to adapt to unexpected events. However, while market risks can bring challenges and setbacks, they can also bring opportunities, and companies that can adapt quickly to changing market conditions may find themselves better off than before.
2. Credit Risk
This is the risk involved in extending credit to customers, as well as taking on credit with suppliers. The customer may not pay what they owe on time or may fail to pay altogether. On the other side of the equation, a company may take on too much debt, overleveraging itself and damaging its relationship with its creditors. These creditors may no longer be willing to do business with the company, or only do so on stricter terms.
3. Liquidity Risk
Liquidity risk involves the possibility of not having enough cash on hand to meet current financial obligations. For example, funds may be tied up in slow-moving inventory, customers may be slow to pay their bills, or the company may be in a seasonal dry spell with expenses exceeding sales. A company may have a healthy-looking balance sheet and income statement, but if it does not have sufficient cash available when bills are due, it may be in trouble.
4. Operational Risk
This risk comes from the business’s own activities and choices, such as strategic decisions, employee errors, fraud, accidents, and lawsuits. Every decision comes with some kind of risk, whether it’s a strategy with uncertain outcomes or one that plays it safe but provides little opportunity for growth. Poor planning, inadequate tools, and lack of documentation or oversight can all increase operational risk, but even good planning and strong infrastructure will run up against unforeseen circumstances from time to time.
Best Practices in Financial Risk Management
There are many different ways to manage risk, both in terms of active choices regarding the amount of risk a company takes on, as well as contingency plans for potential negative outcomes. But the first step to managing risk is identifying and understanding it. Ways to identify risk include:
- Analyze financial statements: this helps identify areas of financial strength and weakness, giving an idea of what funds are available to handle setbacks and what costs can be cut if necessary.
- Review business debts: how much does the company owe in total, and does it have enough cash to keep up with all of its payments? Are any accounts overdue? Can the company afford to take on more debt if necessary?
- Identify weaknesses and challenges within the company: are there inefficiencies that could be addressed? Is the company fully staffed and is that staff happy? Is key technology up to date and well maintained?
- Compare the company to its competitors: do others in the market have better product offerings or lower prices? Is everyone experiencing a downturn or are other companies performing well while yours struggles? Do you have an edge over others?
Having a strong understanding of your own company’s situation as well as your competitors and the exterior forces affecting the market will allow a business to make informed decisions about what risks are beneficial to take on and which are better avoided. It also enables the company to plan for potential negative outcomes from those risks.
Financial Risk Management Techniques
Once financial risks have been identified and analyzed, the company can build strategies to address them. Some of the most common practices in financial risk management are avoidance, reduction, transfer, and retention. The best technique to use will depend on both the type of risk and the company’s risk tolerance and overall business strategy.
1. Risk Avoidance
The most straightforward financial risk management strategy, but not always the easiest. In some cases it is possible to manage risk by avoiding it entirely, such as not investing in risky prospects. For example, a company might choose not to expand into a particular geographic market because of an uncertain political climate, harsher regulations, or an unknown reception from an unfamiliar customer segment.
The downside is that it is difficult to grow without taking on any risks at all. New markets bring uncertainty, but they also bring the potential for new revenue streams and greater profits. Taking on debt creates liquidity and cash flow risks, but without it a company may be unable to open a new location or bring in new equipment to improve efficiency or safety.
This is not to say that risk avoidance is bad, just that the company needs to evaluate the amount of risk involved along with the benefits and potential drawbacks. Sometimes it’s wisest to discard a particular opportunity or option as too risky, and look for a different solution that better fits the company’s needs.
2. Risk Reduction
This involves minimizing the potential for and severity of losses due to risk. While it is difficult to run a business without taking risks, those risks can be planned around to reduce their impact on the company. Careful budgeting can reduce the risk of taking out a loan, while diversifying an investment portfolio mitigates the risk of one investment performing poorly. Planning is a key factor in financial risk reduction regardless of the type of risk being considered.
3. Risk Transfer
Another way to manage financial risk is to transfer some or all of that risk to another party. Insurance is one obvious example of this: by taking out an insurance policy, a company transfers the responsibility of paying for damages to the insurer. The company pays a predictable fee in exchange for the insurer taking on the burden if a less predictable event such as a lawsuit or a theft occurs.
4. Risk Retention
A risk retention strategy means simply accepting that a particular action has risks attached to it and the company may have to deal with them in the future. Some risks simply cannot be predicted, and businesses need to accept that they cannot operate in the market without exposing themselves to some amount of risks that they are unable to prepare for. Some risks can be predicted but the company may be unable to mitigate them, such as an issue that is uninsurable or falls below a policy deductible. This is known as forced risk retention. Finally, some risks may be insignificant enough that the cost of dealing with them is considered to be less than the cost of preparing for them in advance, such as minor shoplifting incidents.
A business will face many different kinds of risk over its lifetime, with much variation in how easy or difficult those risks are to deal with. Because risk is inevitable, careful documentation and planning are key to any financial risk management strategy. The better informed management is about both internal operations and external forces, the better they can determine which strategy is right for any given situation.
Having the right business partner is also important, whether that’s a creditor, accountant, business consultant, insurer, or other service provider. Finding the best company to work with can be a challenge, which is why Bizvibe’s B2B platform provides detailed insights on close to 200,000 finance companies along with tools for comparing and connecting with potential business partners.