4 Major Types of Financial Risks in Business
- FazipayFinancialNews & UpdatesPOS
- May 19, 2023
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What are Business Risks?
Business risk refers to the vulnerability of a business to certain factors that can lower its profits or lead to failure in reaching its goals. For example, if a risk can determine if a company matches its financial goals, it is a financial risk. There are different business risks, which comprise several interrelated factors, including human-related and external policies.
Financial risks may sometimes be subject to the leadership or management decision. In other cases, there are external risks that may be out of the control of the organization. Not all risks are financial risks; there are different business risks. But for the sake of this article, we shall stick to financial risk types, identification, and management.
More on Financial Risks in Business
Many aspects of business risks have financial implications as it affects costs or leads to revenue. However, financial risks refer to the business risks that specifically affect the inflow and outflow of money within a business.
These risks can cause a sudden gain or loss because it affects a company’s credit or debit status. A simple example of financial risk in business is the tendency for a customer to delay payment for goods or services, which affects the company’s cash flow. The longer the credit is delayed, the higher the financial risk involved.
By ripple effect, a delay in a customer’s payment or refusal can increase the financial risk in operation. In addition to short-term debts, a rise in interest rates can imply a higher cost for such a business. However, the company must consider all the financial risks to get things back.
Financial risks exist in practically every industry; as expected, there is financial risk in energy, mainly in the financial sector. The factors that affect the financial risks in a business can be grouped into two major categories, namely;
1. Internal factors: factors that are related to ongoing events within a business. Examples are underperformance of staff, poor investments, insufficient cash flow management, new competition, internal issues with staff members, and other similar factors.
2. External factors depend on events and occurrences outside of your business. Examples include market rate changes, industry changes, poor economic climate, changes in significant laws or government policies, and others.
Types of Financial Risks in Business
There are Four (4) Major Types of Financial Risks in Business, such as
1. Credit risk
Credit risk is the possibility of a creditor not getting a loan payment or getting it late. This risk measures the capacity of the debtor to fulfill payment obligations on the loan. Generally, there are two common types of credit risks: wholesale and retail.
Wholesale credit risks are an organization’s investments, such as the sale of financial assets, new acquisitions, and mergers. On the other hand, Retail credit risks pertain to private and small-scale businesses. This risk may be subject to card payments, mortgages, or other forms of credit to run a business.
Failure to manage credit risks can severely affect a business’s survival. Moreover, if the delinquency of a debt increases, it is a bad sign that the credit risk is going overboard.
2. Market risk
Another essential type of financial risk is market risk, which hinges on the laws of demand and supply. Every company driven towards profit must manage this risk well in terms of all factors within and out of its control. In many cases, market risk is often the result of some measures of uncertainties within the economy affecting companies within the same industry.
For example, variations in prices of assets, liabilities, and variables may lead to an increase in financial market risk. Similarly, the devaluation of a currency can affect a company that pays for raw materials in a foreign currency and sells final products.
3. Liquidity risk
A crucial part of financial risk management is the liquidity risk of a business. Liquidity measures a company’s cash inflow and is ready to use in offsetting debts. It is the business’s capacity to pay off debts as a means of encouraging investors.
On the other hand, the liquidity risk is the possibility that a business may not be able to fulfill its financial commitment. It may be the result of unconvincing cash flow management. Meanwhile, a company may have a high amount of equity and maintain a high liquidity risk.
The reason is that assets cannot be turned into money to pay off short-term debts. So, even if a company boasts of substantial real estate or stock bonds, it may still operate with high liquidity risk. Therefore, every business must retain sufficient liquid assets to meet short-term demands.
4. Operational risk
Operational risks usually arise within an organization from the day-to-day operations, failing to meet its financial obligations. At other times, it may be a tendency not to abide by the financial requirements of the governing body, leading to a fine or suspension of operations.
A typical example of such policy is the anti-money laundering operations that all businesses are expected to observe when transacting across borders. Operational risk may include server outage, technical failure, machine fault, people, or processes.
For example, a process failure could be employees writing a bad check or a failed payment system. In both cases, the company can lose a great deal of money. Operational risks can also be due to certain events beyond the business owner’s control.
For instance, a power outage, natural disaster, or website host downtime may occur. Whatever interferes with a company’s operational behavior and journey from start to finish can be considered an operational risk. It may even include delivery of product or service and getting customer feedback.
How to Manage Financial Risks in Business
The solution to risks is not avoidance or complete protection, which is often not practicable. Instead, a company must learn to manage these risks for much lesser impacts. Many times, the simplest way a company mitigates financial risks is by adopting standard risk management strategies.
In addition, business models are designed to help companies understand, calculate and mitigate risks, including financial risks. Also, financial risk management is an integral part of a business irrespective of industry or size.
There are seven basic steps that business owners can take to manage financial risks in business, such as
- Identifying and measuring the involved financial risks
- Rate the level of risk a company is willing to permit
- Consider an insurance plan against financial business risks
- Identify financial risks associated with cashflow
- Review every financial agreement with customers
- Create a diversity of income sources for your business
- Conduct a regular reassessment of your financial risks
How do financial institutions help with risk-bearing
It will be interesting to know the role of financial institutions in risk-bearing in business. The financial institution with the part assisting a business in managing risk is the Insurance companies. But how do financial institutions help with risk-bearing?
Financial institutions use four significant risk management strategies, such as
- Risk acceptance
The first step in the direction of risk management is the admittance or acceptance of the risk. In some cases, this step may be regarded as risk retention, which is a business’s option to absorb the identified risks. This step is not the same as avoidance or inaction but a step to bear the risk.
- Risk avoidance
The risk avoidance strategy is the step a business takes to remove any involved risk. This step may be necessary if the company identifies that the impact of that risk is too high and cannot be tackled in any other way. Risk avoidance may involve producing a new product or changing certain activities. However, this step may be associated with other factors as well.
- Risk transfer
Risk transfer involves spreading a financial risk over multiple parties to reduce its impact. The sharing parties may include company members, partners, or an outsourced party. Any financial risk that is less likely to occur but can have a significant financial impact is transferable or shareable. As a result, not all financial risks are solvable by risk transfer.
- Risk reduction
In risk reduction, the risk manager attempts to minimize the probability of the risk occurrence and its impact. This process aims to reduce the risk to the barest minimum, the residual risk level. Reducing risk can have immense benefits for your business. Moreover, common risk reduction strategies include new safety measures, operations diversity, and enforcing internal controls.
Risk management analysis and advice
A risk manager reviews the financial capacity of a business and manages all associated risks. The typical steps a professional risk manager takes include
- Data collection
- Review of compliance
- Analysis of results
- Assistance
- Coordination
- Data review
- Implementation
- Supervision
Learning how a financial manager assesses risks can also help decide whether you need a professional risk advisor. Deloitte risk is a famous company in this regard, and the financial advisory professional team is a renowned company. As regards financial risk management, you need to evaluate the level of the financial risk using a financial risk pyramid.
Beyond the major types of financial risks in business, as itemized above, the article further elaborates on a more robust structure for risk management. In addition, business owners can use this article as a guide for understanding financial risks in business and how to deal with them for sustainability and profitability. Meanwhile, infibranches promote financial inclusion and renewable energy through agency banking.