Financial risk in business

Financial risk in business

FINANCIAL RISKS IN BUSINESS

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Financial risk is a situation where a business loses money or is unable to meet its financial obligations as a result of poor cash flow management, high levels of debt, changes in exchange or interest rates, and market transactions or investments with a high level of vulnerability. Financial risk is a concern for any business across different industries as it can lead to negative and unexpected results like insufficient cash flows.

Financial risk is caused by market movements and can be classified into various types as highlighted below:

  • Market Risk – Market risk is the probability of loss due to market volatility, hikes in interest rates or raw material costs, fluctuation in foreign currency values etc. This risk is caused by movement in prices of financial instruments, economic uncertainties, upgrades or innovations in technology, changes in consumption patterns of customers, and variations in the prices of assets, liabilities and derivatives.
  • Credit Risk – This risk arises when a business is unable to meet payment obligations, for example inability to repay a loan or late repayment, failure/inability to pay a supplier etc. Credit risk can therefore be defined as the risk that comes from extending credit to a client who does not pay thereby disrupting your cash flow and reducing your profit. Credit risk can also be defined as the risk that your business may default in debt repayment affecting market reputation, ability to borrow funds from other financial institutions, and investor confidence.
  • Liquidity Risk – Liquidity risk presents a situation where the company is unable to meets its short-term financial obligations due to insufficient cash flow or the inability to quickly convert assets to cash if a sudden need for cash exists. This may be as a result of poor cash flow management, seasonal downturn in revenue, lack of buyers for your assets or an inefficient market.
  • Operational Risk – Operational risk is the likelihood of loss due to the processes, systems, and policies in place within your organization. Sources of this risk include lack of internal controls, technology failures, fraud and mismanagement, employee errors or lack of employee training etc.
  • Currency Risk – Unfavorable changes in the exchange rates of the operating currency and transactional currency leads to currency risk. This is especially the case for businesses that have diversified into foreign markets or that deal in the importation and exportation of goods.

Completely eliminating financial risk is impossible, but companies can employ some easy and inexpensive measures to identify and mitigate the risks. Fundamental analysis, technical analysis, quantitative analysis, ratio analysis, and statistical and numerical analysis can be applied to analyze trends over time and better understand fluctuations. Identified risks can then be managed by diversifying investments, holding the right amount of insurance or sufficient funds for emergencies.

 

References

  1. Juan Pablo Calle (2020). 4 types of financial risks. https://www.piranirisk.com/blog/4-types-of-financial-risks
  2. Eshna Verma (2022). Financial Risk and Its Types. https://www.simplilearn.com/financial-risk-and-types-rar131-article
  3. Business Queensland (2021). Manage Financial Risks. https://www.business.qld.gov.au/running-business/finance/essentials/risks
  4. co.uk. Risk Management. https://www.nibusinessinfo.co.uk/content/financial-risk
  5. Allianz Trade. What Is Financial Risk in Business? https://www.allianz-trade.com/en_US/insights/how-to-assess-financial-risk.html
  6. Madhuri Thakur (2022). Financial Risk. https://www.educba.com/financial-risk/

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