This post discusses financial risk and financial risk management.

WHAT IS A RISK?

Risk is the uncertainty of financial loss. Risk is the possibility of an unexpected or negative outcome. Risk is the uncertainty of financial loss. A risk is anything that may affect the achievement of an organisation’s objectives. Any action or activity leading to a loss can be termed risk. It is the uncertainty that surrounds future events and outcomes. Risk is the expression of the likelihood and impact on a firm’s ability to achieve its objectives. Risk and uncertainty may affect the achievement of goals. Hence, it benefits enterprises or businesses to manage their risk exposures.

TYPES OF RISKS

A firm might face different risks that impact its capability to achieve its goals. Risks can be classified into three types: business, non-business, and financial risks. Let us discuss these three types of risk.

BUSINESS RISK

Business risk is a broad category. Business risk generally refers to enterprises’ risks to maximise shareholder value and profits. In business, risk means that a company’s or an organisation’s plans may turn out differently than initially planned or may need to meet its target or achieve its goals. Business risk threatens its ability to achieve its objectives and financial goals. It applies to any event or circumstance that can prevent an organisation from attaining business goals or objectives. 

The business risk may be internal (e.g., a firm’s strategy) or external (e.g., the global economy). All types of risks should not be managed or treated similarly. A business organisation should understand the risk it faces internally (within the firm) and externally (outside the firm). Risk evaluation enables a firm to determine the importance of risks to the business and decide to accept a specific risk or take action to prevent or minimise the risk. A company should not manage or treat all risks in the same way.

NON-BUSINESS RISK

Non-business risk is a risk that does not arise directly from a business transaction. Non-business risks impact an organisation and are typically beyond the firm’s control. An example of non-business risk arises from changing a firm’s interest rate due to economic and political climates. Hence, risks arising from political and economic imbalances are non-business risks.

WHAT IS FINANCIAL RISK?

Financial risk, as the term suggests, is the risk that involves financial loss to firms. Financial risk arises from a company’s ability to manage its debt and fulfil its financial obligations. The more debt a company has, the higher the potential financial risk. Financial risk occurs when a company cannot meet its obligations to pay back its debts, which could mean that potential investors will lose the money invested in the company. Financial risk may arise in several ways, including instability and losses in the financial market arising from movements in stock prices, currencies, and interest rates. Firms need to embrace a sound financial risk management to improve its financial status.

THE DIFFERENCE BETWEEN BUSINESS RISK AND FINANCIAL RISKS

Business risk relates to the fundamental viability of a business. It refers to a firm’s ability to profit and offset its operating expenses, including salaries, rent, production, and office expenses. On the other hand, financial risk is concerned with the financing costs and the debt the company incurred to finance its operations.

HOW DOES FINANCIAL RISK ARISE?

Financial risk arises through numerous transactions of a financial nature, including sales and purchases, investments and loans, and various other business activities. It can occur due to legal transactions, new projects, mergers and acquisitions, debt financing, the energy component of costs, or through management, stakeholders, competitors, foreign governments, or weather. When financial prices change dramatically, it can increase costs, reduce revenues, or otherwise adversely impact the profitability of an organisation. Financial fluctuations may make it more challenging to plan and budget, price goods and services, and allocate capital.

SOURCES OF FINANCIAL RISK

Here are three primary sources of financial risk:

1. Financial risk arising from a firm’s exposure to changes in market prices, such as interest rates, exchange rates, and commodity prices.

2. Financial risk arising from the actions of, and transactions with, other organisations such as vendors, customers, and counterparties in derivatives transactions.

3. Financial risk resulting from internal actions or failures of the organisation, particularly people, processes, and systems.

TYPES OF FINANCIAL RISK

Here are eight common categories of financial risk:

1. Market risk      

2. Credit risk, 

3. Liquidity risk, 

4. Operational risk,

5. Investment risk, 

6. Compliance risk, 

7. Reputational risk, and 

8. Systemic risk.

Let’s consider these eight categories of financial risks.

Market Risk

Market risk is the risk associated with the fluctuating price of an asset. For example, exchange rate changes will affect the company’s debt repayments and the competitiveness of its goods and services compared with those produced abroad. Market risk relates to a loss due to market volatility, increased interest rates or raw material costs, and fluctuation in the foreign exchange rate.

Credit Risk

Credit risk is the possibility of a lender losing money due to counterparty default. Credit risk is the probability of failing to pay a creditor (such as a bank or a lender) or another party (e.g. a supplier). The company may also incur credit risk by extending credit to customers due to the possibility of them defaulting on a payment.

Liquidity Risk

Liquidity risk is the risk of investors and traders being able to quickly buy or sell a specific asset with drastic price changes. Liquidity risk affects the company’s ability to meet short-term financial demands to execute its business transactions. Key sources of risk are potential cash flow problems because of the seasonal revenue shortfall, inability to convert capital assets to liquid assets, and inefficient market.

Operational Risk

Operational risk is the risk of financial losses caused by failures in internal processes, systems, or procedures. Operational risk is the likelihood of a loss due to the adverse effects of your business’s practices, techniques, or policies. Familiar sources include technical failures, fraud activity, and employee errors. Accidental human mistakes or intentional fraudulent activities often cause these failures. Companies should perform periodic security audits and adopt robust practices and effective internal management to mitigate operational risks.

Investment Risk

Investment risks are the ones related to investing and trading activities. Investment risk is the probability or likelihood of losses relative to the expected return on any particular investment. Generally, a certain level of risk is involved in all kinds of investments. Several investment risks include market, liquidity, and credit risks.

Compliance Risk

Compliance risk relates to losses that may arise when a company or institution fails to follow the laws and regulations of their respective jurisdictions. Many companies adopt specific procedures to avoid risks, such as Anti-money laundering (AML) and Know Your Customer (KYC). If a service provider or company fails to comply, they may be shut down or face severe penalties. Many investment firms and banks faced lawsuits and sanctions due to compliance failures (e.g., operating without a valid license).

Reputational Risk

Reputational Risk, also known as Reputation Risk, is the loss of social capital, market share or financial capital arising from damage to an organisation’s reputation. Reputation Risk is tough to predict or realise financially, as reputation is an intangible asset. However, it is intrinsically tied to ‘Corporate Trust’, which is why reputational damage can negatively impact a firm financially. Criminal investigations into a company or its high-ranking executives, ethics violations, lack of sustainability policies, or issues related to the safety and security of products, customers, or personnel can damage an entity’s reputation.

Systemic Risk

Systemic risk relates to the possibility of a specific event triggering an adverse effect in a particular market or industry. The strong correlation between companies in the same sector evidences systemic risks. For example, the Lehman Brothers collapse in 2008 triggered a severe financial crisis in the US, affecting many other countries. If the Lehman Brothers firm had not been so deeply involved with the American financial system, its bankruptcy would have been less impactful.

THE DIFFERENCE BETWEEN SYSTEMIC AND SYSTEMATIC RISKS

Systemic risk should not be confused with systematic or aggregate risk. Systematic risks can be related to economic and socio-political factors, such as inflation, interest rates, wars, natural disasters, and significant government policy changes. Systematic risk is events impacting a country or society in multiple fields. This may include the industries of agriculture, construction, mining, manufacturing, finance, and more. Systemic risk can be mitigated by combining low-correlated assets and portfolio diversification.

FINANCIAL RISK MANAGEMENT

Financial Risk Management identifies risks, analyses them, and makes investment decisions based on either accepting or mitigating them. It is the process of understanding and managing the financial risks your business might face now or in the future. It is about something other than eliminating risks since few companies can wrap themselves in cotton wool. Instead, it’s about drawing a line in the sand. The idea is to understand what the company is willing to take, what risks should be avoided, and how to develop a strategy based on your risk appetite.

The key to any financial risk management strategy is the plan of action. The organisation will use these practices, procedures and policies to ensure it does not take on the risk it is not prepared to take.

TIPS FOR MANAGING FINANCIAL RISKS BY BUSINESS ORGANISATIONS

Managing financial risks is a high priority for businesses, regardless of size or industry. An organisation should consider various factors affecting financial risk. These can be classified into two categories: external and internal factors. External and internal elements should be considered when undertaking a financial risk assessment. External factors refer to factors that are beyond the control of the company. Conversely, internal factors refer to elements within the company’s management. 

 To effectively manage financial risks, an organisation needs to:

1. Identify and measure the company’s risks.

2. Decide on the level of risk the company is willing to accept and retain.

3. Consider insurance to protect against business risk,

4. Identify potential issues with cash flow,

5. Review the company’s financial arrangements with creditors,

6. Be cautious when providing credit facilities to customers,

7. Diversify the company’s income sources, and 

8. Regular reassessment of the company’s risks.

FINANCIAL RISK MANAGEMENT PROCESS

There are five basic steps involved in managing financial risks. Here are the five steps of the financial risk management process:

1. Identify the risk.

2. Analyse the risk.

3. Evaluate or rank the risk.

4. Treat the risk. 

5. Monitor and review the risk.

See the full video on Financial Risk and Financial Risk Management: https://youtu.be/vT4eReSleng