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Top 4 Financial Risks and How to Avoid Them: A Comprehensive Guide
Starting a business is a risky venture. According to a report generated by Zippia, 22% of U.S. businesses fail within their first year of operation. While the reasons for failure could be many such as cash flow issues, poor management, and resistance to change, not planning for future financial risks is also a key factor. It is, therefore, important for businesses to construct a reliable financial plan by anticipating potential risks and preparing strategies to cope with adverse events. These occurrences include stock market disruption, currency movements, and changes in loan interest rates.
In this guide, we will discuss what financial risk is and what are its types to help develop an effective plan for risk management.
What are Financial Risks?
Financial risks refer to the potential of losing money on an investment or commercial enterprise. For governments, this could mean losing control over monetary policy and defaulting on bonds and debt obligations. On the other hand, companies may fail in a business endeavor that places a financial burden on them, in addition to the possibility of defaulting on a specific debt obligation.
What are the 4 Types of Financial Risks?
Financial risk is a high-priority risk category. If not managed effectively, it can result in dire consequences for businesses, such as catastrophic losses, lawsuits, and bankruptcy. Therefore, it is important for risk managers to understand the four major types of financial risks and be prepared for any future uncertainty.
Let’s look into each of these risk types in detail.
1. Market Risk
This type of risk develops due to movement in financial instrument pricing. Usually, market risk is classified into directional and nondirectional risk.
Directional Risks: This type of risk results from changes in stock prices and loan interest rates.
Nondirectional Risks: These risks are associated with volatility risks, such as unpredictable changes in the price of an underlying asset, such as stocks, bonds, and commodities.
2. Credit Risk
This type of risk arises when a business fails to fulfill its obligations toward its counterparties, which refers to those individuals involved in an investment, credit, or trading transaction.Credit risk is further classified into sovereign risk and settlement risk.
Sovereign Risk: Foreign exchange policies that are challenging to implement often result in sovereign risk.
Settlement Risk: This kind of risk arises when one party makes the payment but the other party is unable to (or doesn’t) fulfill their end of the obligation.
3. Liquidity Risk
The risk associated with liquidity refers to a business’s inability to execute transactions. Liquidity risk is classified into asset liquidity risk and funding liquidity risk.
Asset Liquidity Risk: Asset liquidity risk occurs when there are insufficient buyers or insufficient sellers against sell orders and buy orders, respectively.
Funding Liquidity Risk: Funding liquidity risk arises when a company cannot meet its immediate and short-term obligations in a timely manner, such as clearing monthly outstanding bills.
4. Operational Risk
Operational risk is a category that results from operational failures like poor management or technology faults. Fraud risk and model risk are two categories of operational risk.
Fraud Risk: This type of risk refers to unexpected financial losses due to fraudulent activities such as theft or embezzlement by a member of the organization.
Model Risk: Model risks arise from using insufficient and inaccurate business models for strategic decision-making. For instance, a model risk could be a technology model that fails to meet business needs.
Understanding the Nature of Financial Risks
Assessing the degree of financial risk associated with a business asset can result in informed decision-making.
- Understanding financial risks aids in determining a business’s financial value in a better way, specifically the risk-to-reward ratio
- Financial risks can be estimated by using various analysis tools such as FINCAD, SmartRisk
- Often, financial risks arise from unpredictable external forces such as stock market changes and fluctuations in interest rates and can become difficult to overcome
- Financial risks can spread to different markets or sectors
How do You Identify Financial Risks
The following practices help risk managers identify financial risks and take appropriate steps to control them:
- Knowing the risk factors that a company may be prone to
- Examining corporate balance sheets
- Reviewing financial statements
- Analyzing the shortcomings of a company’s operating plan
- Comparing the company’s financial metrics with other businesses in the same industry
- Employing statistical techniques such as standard deviation and R-square analysis to discover potential risk areas
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Financial Risks in Business with Examples
Businesses face various types of financial risks. These risks can be directional market risks, such as macroeconomic forces or fluctuating market interest rates. Additionally, companies may face credit or default risks when the borrowing business makes poor financial decisions that jeopardize their ability to repay the creditor’s loan. Furthermore, companies also run operational risks due to internal factors such as poor financial planning and management, which prevents them from succeeding.
The Impact of Financial Risks on Markets
Financial markets are often the hub of financial risks. For instance, the Great 2008 Recession in the U.S. is a prominent example of the impact of financial risk on the marketplace. As businesses failed and banks went bust, investors suffered huge losses. The government was forced to reform its monetary policy during this period.
Additionally, there are other risks that impact the market, too, such as volatility. These risks create uncertainty in the fair value of market assets. Volatility risks are measured as a percentage that reflects the stakeholders’ confidence that market returns correspond to the market’s valuation as a whole. By providing insights on rising or declining markets, volatility risks contribute to large swings in stock market share prices.
How Financial Risks Impact Individuals
Individual investors are impacted by three major types of financial risks—liquidity risks, speculative risks, and currency risks.
Investors face liquidity risks in the following two situations:
Market Liquidity Risk
When the market is volatile, the assets and securities may not have the buying or selling rates that compensate for the losses companies are incurring. This results in huge losses to the individual investors who have funded these businesses.
Cash Flow Liquidity Risk
The possibility of such a situation arises when a company lacks the necessary capital to pay off its debt, which results in loan default and subsequent losses for individual investors.
Besides, individual investors are exposed to speculative risks when the likelihood of making a profit from an investment is uncertain. Improper research before investing increases the chances of speculative risks.
Additionally, for foreign investments, individual investors are impacted by currency financial risks due to changes in factors such as interest rates, foreign monetary policy, natural calamities, and political and economic conflicts.
How Can Financial Risk be Avoided?
Although eliminating financial risks entirely may be difficult, reducing the impact of such risks using financial analysis techniques is possible. Individuals and businesses can determine the degree of financial risks for long-term investments using the following methods:
This type of analysis evaluates all aspects of a business, such as the firm’s revenue, profits, and assets.
This method evaluates a firm’s securities using statistics such as historical returns, share prices, and trade volumes.
This technique determines a company’s historical performance using financial ratio calculations.
Identifies potential risks using statistical methods such as R-squared and standard deviation.
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Be Risk-Ready with Emeritus
Mitigating financial risk should be top of mind for any business. Companies need to monitor financial risk trends over time and measure the magnitude of risks using analysis techniques to achieve a better financial goal. Being informed about financial risks a company can face and knowing ways to handle and overcome them can make you a valuable addition to any organization. Emeritus’ online business management courses can help you on your way to mastering crucial concepts in risk management, finding ways to minimize financial risks, and achieving new heights of success!
By Rupam Deb
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