Financial and economic risks are part of everyday reality for businesses in any industry. Regardless of the size of the company, business leaders must spend time planning financial strategy, implementing an optimal financial structure, and analyzing the market, competition and future trends to ensure sustainable growth.

 

What Is Financial Risk?

Financial risk refers to the possible loss of money or uncertainty about the performance of an investment. Financial or insolvency risks are generally caused by instability in the financial and credit markets or the inability to meet financial obligations.

Financial risk is defined as a risk associated with any form of financing. Risk can be understood as a zero return on investment or a lower than expected profit.

 

What Are the Types of Financial Risks?

1.   Credit/counterparty risk

Credit risk is the possibility of financial loss when one party of a financial contract fails to meet its payment obligations. Breach of contract is usually caused by a decline in the creditworthiness of borrowers. However, it can also be related to bankruptcy, losses, liquidity problems or even unwillingness to pay. This type of risk is usually associated with banking institutions, but it also occurs in businesses. For example, when a company makes a forward sale and the customer fails to pay the amount agreed upon.

2.   Liquidity Risk

Liquidity risk arises when one party of a financial contract has assets, but does not have sufficient liquidity to meet its financial obligations. One possible cause is inadequate cash flow management. If a company is not able to sell its assets, has regular losses or cannot cover its debts, it could end up in an illiquid situation.

Cofinia has developed a cash management tool to help our clients optimize their cash flow. You can find it in the ”free tools” section on our website (Cofinia free tools)

3.   Market Risk

This type of risk is related to financial markets. There are four types of market risk:

Interest Rate Risk

Interest rate risk is associated with interest rates going up or down at an inopportune time. For example, if you have a mortgage and your interest rate goes up, your monthly payment will be higher or you will have more monthly payments.

Currency Risk

Currency risk is related to the fluctuation of the exchange rate. An investment could lose value as a result of a negative fluctuation.

Commodity Risk

Commodity risk refers to changes in commodity prices as a result of political or regulatory changes. Energy companies as well as those involved in the processing or production of raw materials are particularly affected by this risk.

4.   Operational Risk

Operational risk occurs when an unforeseen event results in a loss to a company. This type of risk is related to technological errors, human errors, faulty internal processes or external events (fraud, disasters, etc.). It refers to the risk associated with deficiencies or failures in the processes and resources of an organization’s day-to-day operations. This risk is inherent to the activities of an organization, but it can be managed.

 

Tips on Managing Business Risk

1.   Identify Potential Risks

Risk management starts with identifying financial risks that could affect your business. You can start by analyzing the company’s balance sheet to get an overview of your liquidity, debt, interest rate risk, commodity price volatility risk, etc. You should also look at the income statement and cash flow statement to see how your results fluctuate over time.

2.   Calculate Return on Investment (ROI)

Calculating your return on investment gives you valuable information about your business and financial management. This strategy minimizes your financial risk by allowing you to analyze the level of risk associated with each investment and therefore make lower risk decisions.

3.   Conducting a Financial Model of your Business

The implementation of a financial model allows to predict the financial performance of a company as well as the evolution of its financial statements. Forecasts are based on actual data and take into account different assumptions and scenarios in order to draw a realistic picture. It allows companies to make informed decisions. (Article Cofinia financial model)

4.    Diversify Your Risks

Financial diversification is a strategy of investing in different asset classes. Companies should have a diversified portfolio to reduce financial and economic risks. Organizations should invest in both high and low risk assets.

5.   Consult a Financial Expert

Cofinia specializes in financial optimization for small and medium-sized businesses. Our services include the creation of financial projections, the realization of financial modeling, the evaluation of investment projects and the analysis of the profitability of your products and services. Do not hesitate to contact us if you have any questions or if you would like a free evaluation!

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