Financial risks – the chance that your costs, income, or investments might not go according to plan – can affect any company. You should be aware of such risks, and how they can affect your firm. This knowledge will let you implement appropriate risk mitigation strategies and protect your operations (and your bottom line profits) from harm.
What Is Financial Risk?
Financial risk is the possibility that a business might lose money on an investment or new venture. Such a risk can result in the loss of capital and prevent the company from meeting its debt obligations due to diminished cash flows.
Put another way, financial risk is the opposite of financial opportunity. Where opportunity is the chance for a business to make money, risk is the possibility that it could lose money, or not be able to manage its debt. You must prepare for this risk because it can threaten your financial growth and profitability.
Financial risk is a type of business risk. It can come from many places: losses in the financial market, or movements in stock prices, currencies, or interest rates. It can also arise when customers don’t pay for their purchases in a timely manner or when top leaders make risky decisions. The annals of business history are littered with examples of managers betting boldly, and recklessly – and then losing a fortune.
Top Financial Risks to Your Business
We can group financial risks into five major categories.
Credit risk is the risk that a borrower will not repay its financial obligations to a lender. Perhaps you are the credit risk, where you have amassed too much debt and can’t repay your lenders; or your customers are the credit risk, because they cannot pay the debt they owe to you.
All companies take on debt at some point: to finance operations, fund new projects, purchase new assets, or to expand into new markets. Too much debt, however, can place companies in a financially precarious position. If the debt is not properly managed, it can create serious financial issues and even result in bankruptcy.
Impact of credit risk
If you default on debt repayments (known as default risk), your future borrowing costs will increase since lenders will consider you a “high risk” borrower and charge you a higher interest to compensate for their increased risk.
Along similar lines, if you fail to repay your suppliers, they may demand cash up front before shipping more goods or they may stop doing business with you entirely. The loss of critical suppliers will affect your ability to meet your delivery obligations to clients or customers.
If a customer defaults on his or her payment, your cash flows will be affected. And if your company is publicly listed, weak profits could erode its market value and lead to a fall in stock prices.
Regulatory changes create financial risk for companies by materially affecting your potential profits or investments. For example, regulators might require banks to hold more capital in reserve rather than pay it to shareholders as dividends. It is a constant risk for organizations in regulated industries, such as banks, insurance firms, and healthcare organizations.
Impact of regulatory risk
Changing regulations can increase the costs and complexity of conducting business. For example, the Sarbanes-Oxley Act imposes strict recordkeeping requirements on publicly traded companies. Per SOX standards, financial statements must comply with SEC disclosure requirements. In addition, companies must establish strong internal controls to maintain the integrity of financial and accounting information.
Similarly, to comply with ESG (environmental, social, governance) disclosure requirements, organizations must establish a reporting infrastructure, and collect, verify, and document their ESG information – making it a potentially costly and time-consuming endeavor.
Liquidity risk is the risk that you will not be able to meet short-term financial demands or realize value from your assets. Asset liquidity risk is the risk that you may not be able to convert your assets into cash, which can be problematic if you suddenly need to raise cash. (For example, not being able to sell real estate quickly, when you need to make a loan payment in days.) Operational liquidity risk is the potential risk that you may not have enough daily cash to sustain operations.
Liquidity risk can also arise from:
- Seasonal revenue downturns
- Lack of buyers for assets
- Market inefficiencies
Impact of liquidity risk
Potential investors and lenders will assess your liquidity to determine whether you can repay your debt obligations without raising external capital. If you don’t meet their expectations, you may struggle to get your next investment or loan. Lenders will likely charge a higher interest rate before giving you cash.
If you have too much liquidity risk, you may have to sell some assets or find a new revenue stream to reduce the gap between short-term liabilities and available liquid assets (such as cash).
Operational risk can arise from day-to-day business activities or operations. It is the probability of incurring losses due to flawed or broken procedures, systems, processes, or policies. Any of these factors can trigger or increase operational risk:
- Technical failures
- Fraudulent or criminal activities
- Outdated software
- Natural or manmade disasters
- Supply chain disruptions
People can be another source of operational risk, since their inadvertent mistakes or malicious actions can cause financial losses to the company. An example of a non-malicious mistake is failing to encrypt sensitive personal data. Participating in fraud or initiating cyberattacks are examples of malicious activities that increase operational and financial risk.
Impact of operational risk
An operational risk could disrupt business operations, resulting in financial losses. The company’s reputation and competitive position may be damaged. Additionally, customer churn could increase, and you may face legal liabilities and regulatory fines.
Market risk is the risk of losses due to changes in the market where your organization has exposure. It can emerge from factors such as:
- Movements in stock prices
- Interest rate hikes
- Increased costs of raw materials
- Geopolitical events
- Natural disasters
- Fluctuations in foreign currency values
Impact of market risk
Consider a brick-and-mortar retail business. When the COVID-19 pandemic struck, millions of people started shopping online. This affected the sales and revenues of all retail companies lacking an online presence. This is an example of market risk.
Similarly, exchange rate changes may affect your ability to meet your debt obligations. They may also squeeze the sales and competitiveness of your products compared with similar products produced abroad.
Strategies to Mitigate Financial Risk
It’s impossible to eliminate financial risk, but not impossible to manage it. Effective financial risk management includes all these steps:
- Identify each financial risk that may affect your organization
- For each risk, assess the potential impact and probability of occurrence
- Decide how much risk you are willing and able to accept
- Create a risk register and risk management plan
- Implement risk mitigation strategies
- Regularly reassess risks and update the risk register
One way to mitigate financial risk is to purchase insurance. For example, cybersecurity insurance can protect your assets from the financial fallout of cyberattacks and data breaches. You should also implement controls to prevent cash-flow issues and revisit your financial arrangements with creditors, especially if persistent credit risk is a problem.
Conduct due diligence and perform risk assessment on all customers before extending credit. This way, you can identify potential red flags and decide early if you want to extend credit or ask for upfront payments.
Some other strategies to mitigate financial risk and protect your business:
- Use hedging techniques to reduce your exposure to investment or market risks
- Diversify investments to spread the risk
- Maintain sufficient cash flow for emergencies
- Stay updated on foreign markets so you can act quickly if a risk arises
Improve Financial Risk Management with Reciprocity ZenRisk
Automation, actionable insights, a pre-loaded content library, and a single source of truth are all vital for modern-day financial risk management. With ZenRisk, you get all this and more.
ZenRisk is a unified, enterprise-ready platform for risk and compliance management. It will help you build a strong, trusted foundation for your risk management process. It will also enable you to streamline workflows, identify program gaps, and strengthen your security posture.
Schedule a demo to see ZenRisk in action.