In business, no project is completely risk-free. Instead, investing your money into new investments or projects involves taking non-financial and financial risks.
From fluctuations in the market to income loss, it is crucial to identify the potential issues or pitfalls as early as possible to formulate an effective risk management strategy. One of those strategies is undoubtedly the strategy to manage financial risk.
What is financial risk?
Before knowing about financial risk, you should have a clear idea about the actual meaning of financial risk and how it differs from non-financial risk. Financial risk mainly refers to the chances or possibility of losing money.
It can be applied to companies, government organizations, and even individuals. So, in short, whenever you invest money, you may face an inherent risk of losing that money.
What is financial risk management?
Financial risk management means making business decisions based on your analysis and identifying the inherent risk. Whether the risks are quantitative or qualitative, your goal is to strategically offset them with market strategy and financial instruments. Here are some strategies for financial risk management.
- Analysis of financial ratio for measuring liquidity ratio.
- Making appropriate operational adjustments.
- Implementing trade credit insurance to protect credit risk.
- Exercising a foreign exchange contract for currency risks.
How do you identify financial risks, and why is it important?
By identifying financial risks, one can take an active step in protecting the cash flow and improving the performance of a business. In order to identify financial risks, you should start by reviewing the balance sheet or statement of the financial aspects of your business.
You need to clearly understand your business’s actual revenue sources and how the customer credit terms can affect it. For instance:
- You should review both the long-term and short-term debt of your company.
- You should carefully check the cash flow fluctuation over time and how the growth of your revenue can compare to the last quarter.
- You should review the segments of your clients as per geographic region. Also, you need to understand the inherent financial risks of those regions.
Types of financial risk
Here are several types of financial risks you need to identify and manage to ensure the successful operation of your business.
A crucial kind of financial risk is liquidity risk. For instance, if investors cannot buy or sell their securities without a notable price change, completing the transaction can be difficult.
The main reasons for liquidity risk involve an insufficient number of sellers or buyers for the asset. Hence, if you cannot find a reliable buyer, you need to hold onto the asset or even face the risk of losing money.
When you work by investing in any financial instrument or asset, its prices may fluctuate as per the conditions of the market. Thus, factors like the market’s volatility might cause the price to decrease and can offer you financial risk.
Operation risks may occur due to technical issues, resulting in financial risk. Though operational risk can be classified as business risks, it can still lead to financial risk by leading to system breakdowns or even human fraud or error.
This kind of financial risk is related to credit and default risks. If your business gives a loan to another company or party, you may face an inherent financial risk if the borrower cannot repay you.
Some credit risks may even relate to currency exchanges. You may lose money because of unfavorable policies or exchange rates, which may lead to difficulties in making full payments.
Therefore, to run an organization properly without facing any financial risk, you need to know about different financial risks and how to identify and manage them.