Every company is subject to a degree of financial risk. Not all financial risks are able to be controlled, for example, disruptions to the stock markets, changes in interest rates, and even currency movements.
Since it’s impossible to predict financial markets accurately, risk management is a crucial aspect of any company’s long-term plans. Business owners must try to anticipate potential risks by preparing strategies to cope with any adverse events.
Below we have categorised and discussed financial risks in six different ways. These are Credit Risk, Market Risk, Operational Risk, Liquidity Risk, Legal Risk and Equity Risk.
Sometimes referred to as Default Risk, arises from borrowing money. This is something that almost every company will need to do at some point, whether to fund start-up costs or perhaps to enable the business to expand and grow. Companies must ensure that they can meet its repayments because a failure to comply with the terms of the loan carries severe penalties.
However, Credit Risk also refers to customers being unable to pay for their goods or services. Most businesses need to extend credit to their clients at one point or another, which comes with its own pitfalls. Customers defaulting on their payments will have a knock-on effect far beyond the time and costs associated with debt recovery.
Where a business has investors or shareholders, they will be adversely affected by Credit Risk, which can cost them highly in interest or loan payments. Debt collection costs merely exacerbate this effect.
With the rise of the internet, how a business operates has changed almost beyond recognition. As an increasing number of consumers head online to source products and services, brick-and-mortar stores are feeling the pinch – a perfect example of Market Risk. A business market is subject to changing conditions, and this can affect its profitability.
For example, businesses that prepared in advance for the rise in technology, known as early adopters, have thrived and grown throughout the online evolution. But companies that failed to plan well in advance for the changes in the way in which consumers purchase have struggled to keep afloat.
Operational risk refers to the dangers faced during day-to-day management of a business. The term covers a broad spectrum of potential risk factors, including legal problems, HR issues and ineffective management. Even the failure of technical equipment can have an impact on a company’s finances, so it’s essential to have plans in place to cover all eventualities.
Generally speaking, Operational Risk is two separate categories: Model Risk and Fraud Risk. Model Risk covers the company’s plans for growth and marketing, which, if not thought through very carefully, can lead to financial calamity. Fraud Risk, as the name suggests, is concerned with any fraudulent or incompetent economic behaviour within an organisation that comprises its integrity.
Robust cash flow management is essential if a business is to avoid liquidity risk. The term refers to the level of risk involved in ensuring that company assets can quickly transform into available cash. This is of particular concern for seasonal businesses which are subject to regular downturns in trade during lean periods.
When a business finds itself unable to pay its staff or source more stock, it can very quickly lead to significant problems. In extreme circumstances, this may result in the closure of an otherwise viable business, reinforcing the need to keep a close watch on cash flow.
Liquidity Risk is often broken down further into two separate classifications. Asset Liquidity Risk can arise from either an insufficient number of buyers or an inadequate number of sellers. But it also refers to the risk involved in buying an asset that has little or no resale value. Funding Liquidity Risk, on the other hand, applies to the business’ daily cash flow operations.
Legal matters require the assistance of trained lawyers, with the associated costs. The legal risk for a company refers to any financial losses that arise as a result of legal proceedings.
Equity Risk refers to the level of risk involved for businesses trading on the Stock Market. A volatile market can make it almost impossible for a company to value any equity stocks that it holds accurately. In particular, a falling market can spell disaster for a business that hasn’t undertaken the necessary degree of financial planning.
While some risks may be out of your control, make sure when you are opening a bank account for a business that your chosen bank provides a high level of cover and support for certain financial risks.