FINANCIAL RISKS

Financial risk is often unavoidable in business. Sometimes, it’s even acknowledged as a

necessary condition to achieve a desired return. Even companies with the most thoughtful,
strategic business leaders encounter influences beyond their control.

Financial risk is a broad term for situations that can lead to an adverse commercial impact, such
as reduced profitability, loss of capital, strained cash flow and possibly business closure. Risk
and reward tend to have a direct correlation — the greater the potential risk, the bigger the
potential payoff.

Financial risk is the likelihood that the organization will lose money on a business investment or
other decision, including loss of capital.

Financial risk is inherent in any business enterprise, and good risk management is an essential
aspect of running a successful business. Risk management is the preventative approach to
mitigating financial risks. It’s a combination of identifying, monitoring, controlling (where
possible) and planning for potential risks to curtail their impact.

There are different ways to categorize a company's financial risks. Below are six types of risks
that fall into the financial sphere, including operational risk, credit risk, market risk, liquidity
risk, legal risk, and foreign exchange risk.

OPERATIONAL RISK

Operational risk in the context of financial risk management encompasses any unforeseen events
in day-today operations that could have an effect on the company’s bottom line. For example,
having a manufacturing plant or data center go out for several hours could end up in a loss of
revenue for the business. These types of risks are realized when systems, processes, people, or
external events interfere with daily functions. It’s difficult to completely eliminate operational
risk — since as long as there are processes, people, and systems, there will be errors. However,
by putting mitigation strategies in place to limit operational risk to an acceptable risk tolerance
threshold, companies can continue to thrive in spite of any residual risk.

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Organizations risk financial losses due to ineffective internal systems, processes, or human
factors. Operational loss/risk, encompasses various hazards, including errors, fraud, disruptions,
and misconduct and besides finances, can impact an organization’s reputation.

How to manage operational risk

 Implement strong internal controls.

 Conduct risk assessments.

 Monitor systems and processes.

 Train staff

 Develop backup plans

LIQUIDITY RISK

Liquidity risk is the risk that a person, business, or financial institution will not be able to meet
its financial obligations when due. This can happen when insufficient cash is on hand or when
assets cannot be easily converted into cash. Liquidity risk involves asset liquidity and operational
funding liquidity.

Asset liquidity refers to the ease and speed with which a company can convert its assets into cash
should there be a sudden, substantial need for additional cash flow.

Operational funding liquidity refers to the amount of daily cash flow being enough to meet short-
term liabilities and obligations, and keep the business running smoothly.

General or seasonal downturns in revenue can present a substantial risk if the company suddenly
finds itself without enough cash on hand to pay the basic expenses—salaries, vendor bills—
necessary to continue to function. This is why cash flow management is critical to business
success—and why analysts and investors look at metrics such as free cash flow when evaluating
companies as an equity investment.

Liquidity risk can be caused by various factors, including a sudden drop in market demand, a
restriction on credit availability, or the inability to sell assets quickly.

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The consequences of liquidity risk can be severe, including financial hardship, higher borrowing
rates, and reputational damage.

CREDIT RISK

Businesses face credit risk when they extend credit to customers, essentially allowing them to
make purchases without immediate payment. As long as customers who buy on credit pay their
bills, the company avoids loss. If they default on payments, then the company has a problem.

Credit risk is the risk that a customer or borrower fails to meet their financial obligations, like
payments. This risk can be present in different financial instruments, such as loans, bonds, credit
derivatives, and trade receivables. Companies can take steps to mitigate credit risk through
insurance and collateral, however, some parties may default regardless. Organizations should
understand and benchmark any historical instances of credit defaults, analyze trends, and act
accordingly to manage future credit risks, like through flagging high-risk transactions or
preventing buyers with poor credit from taking out loans. Credit checks are another common
means used to evaluate a customer or borrower’s eligibility for deferred payments.

Credit risk can also refer to the company's credit line with suppliers. A company must ensure that
it always has sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise,
suppliers may either stop extending credit to the company or even stop doing business with the
company altogether.

The borrower’s creditworthiness is among the factors that influence credit risk. Lenders and
investors can manage credit risk by conducting in-depth credit evaluations and establishing
reasonable interest rates and loan terms, amongst others.

MARKET RISK

For businesses, market risk can relate to changing conditions in the specific marketplace in
which it competes. Market risks have to do with capital markets and financial markets as a
whole, such as a risk in a particular sector or geopolitical effects on macroeconomic conditions.
Market risk is the risk of financial losses caused by changes in market conditions. It includes the
uncertainty and volatility caused by many factors, such as interest rates, exchange rates,

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commodity prices, and stock market prices. Market risk can impact various financial instruments
and assets, including stocks, bonds, derivatives, and currencies.

High interest rates in the market discourage people from taking out loans and encourage savings,
providing a potential risk to lenders and banks’ revenue. The availability of capital can impact
companies’ valuations. Market risks are difficult to predict and may come about suddenly, but
maintaining a strong Finance Risk Management program can keep an organization vigilant and
prepared.

Types of Market Risk

Changing Consumer Preferences

One example of market risk is the increase in consumers who prefer shopping online. This aspect
of market risk has presented significant challenges to traditional retail businesses.

Many companies that have adapted to serving an online shopping public have thrived and seen
substantial revenue growth, while other companies that couldn't adapt, have been slow to adapt,
or have made bad decisions relating to the changing marketplace have fallen by the wayside.

Agility of Competitors

Another element of market risk is the risk of being outmaneuvered by competitors.

The global marketplace is increasingly competitive, often with narrowing profit margins. The
most financially successful companies are those that offer a unique value proposition that makes
them stand out from the crowd with a solid marketplace identity.

To minimize potential losses and maximize returns, market risk can be managed using methods
such as diversification, hedging, and thorough research of market movements.

LIQUIDITY RISK

Liquidity risk is somewhat like the inverse of credit risk, in which the organization is unable to
meet its financial obligations or make payments — due to a lack of cash or funds. Liquidity risk
can be an existential threat to an organization, and even lead to a going-concern risk. Managing
cash flow, liabilities, and assets in a balanced way and maintaining regular FRM practices and

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controls can help organizations limit the risk of liquidity and keep the company’s cash flow
healthy.

LEGAL RISKS

Legal or compliance risks are those risks associated with a loss due to failing to meet legal,
regulatory, or compliance requirements that are necessary for a business organization its industry.
Legal risks can include the risk of financial loss due to lawsuits, like with a defective product
causing bodily injury, while the risk of noncompliance can lead to fines and lost sales.

Legal and regulatory risk arises from the potential impact of legal actions on the business
operations and financial performance of individuals, companies, or sectors. It encompasses the
risk of non-compliance with applicable laws and regulations and the risk of adverse legal
judgments or penalties. Effective legal and regulatory risk management involves ensuring
compliance, staying updated on legislative and regulatory developments and seeking legal advice
to navigate complex matters.

FOREIGN EXCHANGE RISK OR CURRENCY RISK

Foreign exchange or currency risks are realized when unexpected changes to the foreign
currency exchange rate have an impact on the organization’s financial standing. Fluctuations in
foreign exchange rates can have a substantial impact on the valuation of an organization’s
investments, financial positions, and holdings, especially when they’re sudden and unforeseen.
This type of risk is more likely to occur in multinational corporations; companies that are heavily
invested in imports and exports; and organizations that have significant financial holdings in
foreign countries. Managing this economic exposure can be achieved through operational
strategies, like diversifying the locations of facilities; markets where products are sold; and
sourcing of materials. Currency risk-specific mitigation options are also available, such as
currency flows and currency swaps that allow companies to limit the impact of currency
exchange rate changes.

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 FINANCIAL RISK MANAGEMENT

Financial risk management strategies are a plan of action or policies that are designed to deal
with various forms of financial risk. The strategies are important for any firm or individual to
manage the inherent financial risks that come with operating within the economy and financial
system.

Financial risk management is a function of enterprise risk management (ERM) that has to do
with handling, identifying, and treating financial risks. Financial risk management is an
especially sensitive and critical aspect of risk management for many companies, as it has to do
with the safeguarding of the organization’s finances and the prevention of loss. Healthy cash
flow, diversification, and competent financial management all play a hand in an effective
financial risk management strategy. Good financial risk management leads to cost savings, better
decision-making, and improved returns.

By understanding their financial risk landscape and taking a proactive approach to financial risk
management (FRM), companies can stay ahead of potential threats to their bottom line and make
informed, insightful investments and decisions. FRM best practices offer companies ways to
handle the most common financial risks, and reduce or eliminate the likelihood or impact of
those risks. With a financial risk management approach and regular risk assessments, an
organization can manage various types of risks, and gain an advantage in a market full of
volatility.

A company's management can control risk with varying levels of success. Some risks can be
directly managed; other risks are largely beyond the control of management. Sometimes, the best
a company can do is to try to anticipate possible risks, assess the potential impact on the
company's business, and be prepared with a plan to react to adverse events.

COMPONENTS OF FINANCIAL RISK MANAGEMENT

 Risk Identification

 Risk Analysis

 Deciding on a strategy to manage these risks

 Monitoring the success of the strategy

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Risk Identification

Risk identification is always the first step in any risk assessment process, and this applies to
financial risk assessments as well. In addition to learning from past experiences, published
standards, and best practices, organizations should consider a few other methods of identifying
financial risks. A good starting point for identifying risks is to examine the company’s financial
statements, disclosures, balance sheet, and other key reports and documentation, and noting any
observations. Assessors should pay particular attention to debt, expenses, and liabilities, as well
as cash flow. Financial operational risks should emerge too, with all identified risks recorded in a
risk register. Risk management software can help internal teams manage their centralized risk
register and collaborate with teammates to complete treatment efforts.

Risk Analysis

The risk analysis (sometimes known as the risk assessment) step follows the risk identification
phase and requires assessors to evaluate the likelihood that a risk could be realized, and the
significance of the impact should the risk be realized. By combining the likelihood score of the
risk and impact score of the risk, the risk can be prioritized and categorized for treatment.
Although risk analyses and scoring should have some bearing on the prioritization of
remediation efforts, the company should also consider business objectives, goals, and priorities
when deciding which risks to treat before others.

Deciding on a strategy to manage these risks

There are various risk management strategies available to both individuals, corporations, and
financial institutions. At the corporate level, they include;

 Risk avoidance: elimination of activities that can expose the corporation to risk; for
example, the corporation can avoid expanding operations to a geographical area that has
high political and regulatory uncertainty.

 Risk reduction: mitigating potential losses or the severity of potential losses; for
example, a corporation may use hedging on foreign currency transactions to reduce their
exposure to currency fluctuations.

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  Risk transfer: the process of transferring risk to a third party; for example, a corporation
may purchase insurance on their property, plant, and equipment to transfer the risk of
damage and theft to the insurer.

 Risk retention: the process of accepting responsibility for a particular risk; for example,
a corporation may accept risks of volatile input costs without using any hedging or
insurance.

Monitoring the success of the strategy

Continuously monitor risks and review risk mitigation strategies to adapt to evolving conditions

HOW TO AVOID FINANCIAL RISK

By identifying and monitoring risks, a company is better positioned to mitigate their financial
impact. The four approaches to mitigating financial risk are avoidance, reduction, transference
and acceptance. Avoidance involves changing course to dodge the factors that cause the financial
risk.

Diversification: the impact of potential losses from a single investment can be reduced by
diversifying assets across different asset classes, industries, or geographical areas. Diversification
is a way to spread risk across multiple areas. When businesses hold investments in other
companies through stocks or ownership stakes, selecting a variety of industries helps minimize
the risk that investments all rise and fall together. Further, diversifying investments between
equity and debt can help minimize volatility and risk. Similarly, diversifying a business’s income
streams, so as not to rely on a small number of products or customers, is another way to hedge
financial loss and minimize risk.

Financial Planning: When creating a financial plan, consider the income, expenses, savings,
investments, and debt. Set realistic objectives and outline how to reach them.

Risk Assessment: When making financial decisions or investments, thoroughly assessing the
potential risks involved is crucial. By doing so, one can make informed choices, develop
appropriate risk mitigation strategies, and ultimately protect one’s financial well-being.

Insurance coverage: Obtain comprehensive insurance policies to transfer certain risks, such as
property damage, liability, or business interruption.

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Hedging: Utilize financial instruments like derivatives to hedge against fluctuations in interest
rates, exchange rates, or commodity prices. Professional money managers, traders, individual
investors, and corporate investment officers use hedging techniques to reduce their exposure to
various risks. Hedging against investment risk means strategically using instruments such as
options contracts to offset the chance of any adverse price movements

Contingency reserves: Set aside contingency funds to address unexpected financial challenges
and stabilize operations during turbulent times.

Compliance and regulation: Stay up to date with relevant regulations and ensure strict
compliance to mitigate legal and regulatory risks.

Debt management: Manage debt levels carefully, considering interest rate risks, and maintain a
healthy debt-to-equity ratio.

Strategic partnerships: Collaborate with reliable partners to share risks and leverage their
expertise in specific areas.

Employee training: Train employees to recognize and respond to potential risks, fostering a
risk-aware culture within the organization.

Market research: Conduct thorough market research to anticipate changes and trends that may
impact the company’s financial performance.

HOW TO IDENTIFY FINANCIAL RISKS

Identifying financial risks involves considering the risk factors that a company faces. This entails
reviewing corporate balance sheets and statements of financial positions, understanding
weaknesses within the company's operating plan, and comparing metrics to other companies
within the same industry. Several statistical analysis techniques are used to identify the risk areas
of a company.

HOW TO HANDLE FINANCIAL RISK?

Financial risk can often be mitigated but it may be difficult or unnecessarily expensive for some
to completely eliminate the risk. Financial risk can be neutralized by holding the right amount of

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insurance, diversifying your investments, holding sufficient funds for emergencies, and
maintaining different income streams.

TOOLS TO CONTROL FINANCIAL RISK

Many tools are available to individuals, businesses, and governments that allow them to calculate
the amount of financial risk they're taking on. The most common methods that investment
professionals use to analyze risks associated with long-term investments or the stock market as a
whole include:

 Fundamental analysis: The process of measuring a security's intrinsic value by

evaluating all aspects of the underlying business including the firm's assets and its
earnings

 Technical analysis: The process of evaluating securities through statistics and looking at
historical returns, trade volume, share prices, and other performance data

 Quantitative analysis: The evaluation of the historical performance of a company using

specific financial ratio calculations

 The debt-to-capital ratio: measures the proportion of debt used given the total capital
structure of the company when evaluating a business. A high proportion of debt indicates
a risky investment.

 The capital expenditure ratio: divides cash flow from operations by capital
expenditures to see how much money a company will have left to keep the business
running after it services its debt.

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 Reference

Adams, H. (2024) Understanding financial risk plus tools to control it

[Link]
CFI Team “Financial Risk Strategies” [Link]
map/sell-side/risk-management/financial-risk-management-strategies/
Lancaster, A., Goff, S. (2023) “Financial Risk Management
Fundamentals”[Link]
Russo, K. (2023) 15 Ways to Minimize Financial Risks in Business
[Link]
[Link]

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