Risk is inherent in any business enterprise, and good risk management is an essential
aspect of running a successful business. A company's management has varying levels of
control in regard to risk. Some risks can be directly managed; other risks are largely beyond
the control of company management. Sometimes, the best a company can do is 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.
There are many ways to categorize a company's financial risks. One approach for this is
provided by separating financial risk into four broad categories: market risk, credit risk,
liquidity risk, and operational risk.
1. Market Risk
Market risk involves the risk of changing conditions in the specific marketplace in which a
company competes for business. One example of market risk is the increasing tendency of
consumers to shop online. This aspect of market risk has presented significant challenges
to traditional retail businesses.
Companies that have been able to make the necessary adaptations to serve an online
shopping public have thrived and seen substantial revenue growth, while companies that
have been slow to adapt or made bad choices in their reaction to the changing marketplace
have fallen by the wayside.
This example also relates to another element of market risk—the risk of being
outmaneuvered by competitors. In an increasingly competitive global marketplace, often with
narrowing profit margins, the most financially successful companies are most successful in
offering a unique value proposition that makes them stand out from the crowd and gives
them a solid marketplace identity.
2. Credit Risk
Credit risk is the risk businesses incur by extending credit to customers. It can also refer to
the company's own credit risk with suppliers. A business takes a financial risk when it
provides financing of purchases to its customers, due to the possibility that a customer
may default on payment.
A company must handle its own credit obligations by ensuring 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.
3. Liquidity Risk
Liquidity risk includes asset liquidity and operational funding liquidity risk. Asset liquidity
refers to the relative ease with which a company can convert its assets into cash should
there be a sudden, substantial need for additional cash flow. Operational funding liquidity is
a reference to daily cash flow.
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 necessary to
continue functioning as a business. 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.
4. Operational Risk
Operational risks refer to the various risks that can arise from a company's ordinary business
activities. The operational risk category includes lawsuits, fraud risk, personnel problems,
and business model risk, which is the risk that a company's models of marketing and growth
plans may prove to be inaccurate or inadequate.
Some CEOs and business owners go through years of making mistakes before they master the art
of lowering financial risk. Knowing some of the common mistakes many successful entrepreneurs have
made will help you make wiser business decisions. Use these five financial risks as a basic outline to
keep you on track to reducing your overall business risk:
1. Never under-price your solutions.
Some people have a tendency to price their products or services low during the beginning days of their businesses.
The idea is that low prices will set them apart in their market. However, as operating costs increase, so will the need to
increase prices. When this happens, your loyal customers may be offended, feeling that price increases are unfair.
The wiser route would be to come up with a more effective way to differentiate your solutions from your competitors’.
That way, you’re able to justify your increasing prices. It’s impossible to make a profit if your solutions are priced too
low. To avoid this financial risk, do some extensive market research. Then, price your solutions near or just above the
market average.
2. Don’t hire until you have the funds to afford it.
Another common financial risk is hiring employees based on contracts and promises. In the business-world, there are
times when contracts become promises of future revenue. Yet, contracts are not equivalent to actual money in the
bank. When it’s time to pay your employees, you’ll need to have the funds in your account to cover the payroll costs.
So, resist the urge to hire more employees than you can afford before your promises are actually converted into
money.
3. Never borrow money you don’t need.
Qualifying for a business loan can feel like a great accomplishment. But, just because a lender approves you doesn’t
mean you need to take on the debt. Banks make money by collecting interest on various types of loans, including
business loans. The best way to lower this financial risk is to pay little to no interest at all. Therefore, if you don’t truly
need a loan, don’t sign for one. And, if you do find yourself in need of funds, borrow only what you need to help your
business grow. Paying interest increases your financial risk, decreasing your overall ROI.
4. Don’t depend on just one revenue source.
Think of your business revenue like you would your stock portfolio. When it comes to the investments in your portfolio,
the majority of your company’s revenue needs to come from more than one source. Oftentimes, as a startup, you
spend most of your time serving your early customers. This makes it hard to venture into other markets and build new
accounts. Those early streams of revenue tend to die off over time. So, avoid this financial risk by concentrating on
building other revenue sources as well.
5. Don’t fill too many overhead positions.
Every person within your company who receives paid compensation should have a justifiable position. Some of these
types of positions include those who serve customers, develop products and convert leads into sales. Hiring
“overhead” people can be a serious financial risk, especially if they don’t produce anything or make the company
money. This will effectively decrease your company’s overall ROI.
Not all financial risks will have a negative impact on your business. Yet, there are those that could
mean the difference between building a successful company and closing up shop early in the game.
Reduce your company’s overall business risk by avoiding these five mistakes and financial risks from
the very beginning.