Managing financial risk is a critical aspect of running a successful business. Financial risk is the potential for financial loss due to unexpected events or changes in the market. Understanding and effectively managing financial risk can protect your business from economic instability and ensure its long-term success.
Types of Financial Risks
Financial risks may be caused either by external or internal factors. The following are the types of risks that we use to classify and analyze financial risks:
In business, we often have to sell our products or services to customers on credit. This means that they have a specific amount of time before they have to pay the invoice. Unfortunately, there is always a risk involved here that the customer will not make the payment, and the business will be left having incurred the cost to provide the goods/service and not receive any sales revenue. This type of risk is known as credit risk. It is a risk of loss due to a borrower’s inability to make required payments on a loan. As a lender, you face credit risk if you lend money to a borrower who cannot repay it.
The risk of loss due to changes in the market, such as fluctuations in the value of assets is market risk. Various factors, including changes in economic conditions, interest rates, and political events, can cause market risk.
Let’s think of a small company manufacturing car parts. The company has received a large order from its client. To fulfill the order, the company signs purchase contracts with its suppliers for a substantial amount of raw material. The company has thus incurred an upfront liability that will fall due before the client receives their order and pays. Hence, the company has a risk exposure related to having sufficient cash to pay the supplier invoices on their due date. This risk is greater if the company’s existing assets cannot be sold quickly for cash without significantly reducing their price. This type of risk is known as liquidity risk. It is the risk of not having enough liquid assets that you can’t sell quickly enough to meet financial obligations. If you hold an asset that is difficult to sell, you may face liquidity risk if you need to access the funds quickly.
Often, businesses fail to thrive due to internal risks. There is always a risk in organizations that a major machinery malfunction will disrupt your procedures or your employees will make errors/fraud. Operational risk thus refers to loss due to operational failures, such as equipment failure, employee errors, or data breaches. Operational risk can also include the risk of loss due to legal or regulatory changes.
This is the risk of loss due to damage to a company’s reputation. It can be caused by negative press, social media attention, or a company’s failure to meet customer expectations. One real-life example of a company that suffered due to a bad reputation is Wells Fargo. In 2016, it was revealed that Wells Fargo employees had opened many unauthorized bank accounts and credit card accounts in their customers’ names to meet sales targets. This led to widespread public outrage and a significant decline in the company’s reputation.
As a result of the scandal, Wells Fargo faced several consequences, including:
- Fines and legal settlements
- Reputational damage: According to Brand Finance, the scandal severely damaged Wells Fargo’s reputation, and the company’s brand value declined by $10 billion. The company’s customer satisfaction ratings also dropped significantly.
- Loss of business: Many customers closed their accounts with Wells Fargo in the wake of the scandal, leading to a decline in the company’s business. In the years following the scandal, the company’s stock price and earnings also declined.
Overall, the Wells Fargo scandal demonstrates the potentially severe consequences that a company can face due to a decline in reputation. Businesses need to prioritize maintaining a positive reputation to avoid similar risks.
Interest rate risk
Consider a situation where XYZ company borrows money from a bank to expand its operations and purchases a new factory. There are risks involved with the changes in interest rates. If the loan taken is a variable rate loan, your interest rates will fluctuate with the market conditions, and they may increase. And if the loan taken is a fixed-rate loan, it might be less risky than a variable-rate loan, but there would still be risk exposure. Conversely, consider a situation where a company lends or invests money. The risks associated with the variations in interest rates also apply in this situation. Hence, interest rate risk is the risk of loss due to changes in interest rates. If you have investments or loans with variable interest rates, you may face interest rate risk if rates rise or fall significantly. Changes in interest rates lead to higher or lower interest amounts.
Political risk can be particularly relevant for businesses operating in countries with unstable governments or political environments. Political risk is the risk of loss due to political instability or changes in government policies.
5 Proven Tips to Manage Business Financial Risks
Often businesses are aware of the benefits of a good financial risk management system. However, the tough part is identifying and implementing the appropriate risk treatments.
Here are some tips for managing business financial risks:
1. Financial Planning & Analysis
Having a financial plan in place can help you anticipate potential risks and take steps to mitigate them. A financial plan for businesses is an important tool for mitigating risks and ensuring financial stability. By understanding the risks an organization is exposed to, it can take steps to mitigate or eliminate them. For example, a financial institution may use financial risk modeling to identify the risks associated with lending money to a particular borrower. If the risk is deemed too high, the institution may choose not to make the loan or require the borrower to provide additional collateral. By taking these steps, the institution can protect itself from the potential losses resulting from a borrower defaulting on a loan.
2. Keep cash reserves
Having cash reserves on hand can help you manage unexpected financial storms and maintain financial stability. It is also good practice for businesses to create their cash flow forecast to predict the inflow and outflow of cash in their business over a given period. This can help you anticipate potential cash shortages and take steps to address them.
3. Manage debt carefully
Taking on too much debt can be a financial risk, so it’s important to manage debt carefully and only take on as much as your business can handle.
4. Set the right Key Performance Indicators (KPIs):
Setting the right key performance indicators (KPIs) for business risk management is important because it helps you identify potential risks and track your progress in managing them.
Here are some steps to follow when setting KPIs for risk management:
- Identify the most relevant risks to your business: Consider the specific risks that are most likely to affect your business.
- Determine the impact of each risk: Consider the potential impact of each risk on your business, including the likelihood of occurrence and the potential severity of the impact.
- Select relevant metrics to help you measure your progress in managing each risk. For example, if you are trying to mitigate financial trouble, you might track metrics such as cash reserves, debt-to-equity ratio, or return on investment.
- Set target values for each metric: Determine the target values for each metric that will indicate that the risk is being effectively managed. These target values should be based on industry benchmarks and your business’s specific goals and objectives.
- Regularly review and adjust your KPIs: As your business changes and new risks emerge, it’s important to regularly review and adjust your KPIs to ensure they are still relevant and helpful in managing risks.
5. Insure your business
Protecting your business with insurance can help you mitigate financial risks related to natural disasters, accidents, and other unexpected events.
Importance of Managing Business Financial Risks
The case of Bernie Madoff is an example of how underestimating risks can have serious consequences. Madoff was a financier and investment adviser convicted of running a Ponzi scheme. A Ponzi scheme is a type of investment scheme in which investors receive returns using the investments of newer investors. This is a fraudulent scheme. Madoff’s Ponzi scheme was able to operate for decades, partly because he could gain his investors’ trust by consistently delivering returns. However, these returns were not generated through legitimate investment activities but rather by using the investments of newer investors to pay earlier investors.
The Madoff case is an example of how risks can be underestimated when individuals or organizations fail to properly assess the underlying investments or business practices of the parties they are dealing with. In this case, Madoff’s investors failed to adequately scrutinize his investment strategies, leading to significant financial losses when the Ponzi scheme collapsed. Other than the Madoff case, the case studies of Barings Bank, Arthur Anderson, Procter & Gamble, Madoff, and Enron are all examples of companies that underestimated the business financial risks.
Modern businesses are exposed to new business financial risks each passing year. Such risks include cyber attacks, market volatility, and environmental, technological, and talent risks. Businesses are exposed to increasing risks. This highlights the importance of conducting due diligence and thoroughly evaluating the risks associated with any investment or business venture.
This guide explained the different types of financial risks and provided five proven tips for managing business financial risks. Expertise Accelerated deploys high-quality and trained FP&A professionals to assess your business’s financial risk. Our professionals prepare budgets and cash flow projections with accuracy to minimize the business financial risk of the client’s company.