Financial risk management in business
Financial and economic risks are part of the daily reality of businesses, regardless of the industry. Regardless of the size of the organization, business leaders must devote time to planning the financial strategy, putting in place an optimal financial structure and analyzing the market, the competition and future trends in order to ensure sustainable growth.
What is financial risk?
Financial risk refers to the possibility of losing money or the uncertainty of the performance of an investment. Financial or insolvency risks are generally due to instability in financial and credit markets or the inability to meet financial obligations.
Financial risk refers to the risk associated with any form of financing. Risk can be understood as zero return on investment or as less profit than expected.
What are the types of financial risk?
1) Credit/counterparty risk
Credit risk represents the possibility of incurring financial losses when one of the parties to a financial contract fails to meet its payment obligations. The breach of contract is usually caused by the decrease in the creditworthiness of the borrowers. However, it can also be linked to bankruptcy, losses, liquidity problems or even a lack of willingness 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 does not pay the agreed amounts.
2) Liquidity risk
Liquidity risk arises when one of the parties to a financial contract has assets, but does not have enough liquidity to meet its financial obligations. One possible cause is poor cash flow management. If a company is unable to sell its assets, has regular losses, or cannot cover its debts, it could find itself in a situation of illiquidity.
3) Market risk
This type of risk is linked to financial markets. There are four types of market risk :
Interest rate risk
Interest rate risk is associated with the rise or fall of interest rates at an inopportune moment. For example, if you have a mortgage and your interest rate increases, your monthly payment will be higher or you will have more monthly payments to pay.
Risk of change
Currency risk is associated with fluctuations in the exchange rate. An investment could lose value following a negative fluctuation.
Equity risk refers to the possibility of losing capital between the time an asset is purchased and its resale.
As the name suggests, commodity risk refers to changes in commodity prices following political or regulatory changes. Companies in the energy sector as well as those involved in the transformation or production of raw materials are particularly affected by this risk.
4) Operational risk
Operational risk arises when a contingency results in losses to a business. 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 activities. It is an inherent risk of doing business, but it can be managed.
Tips for managing business risk
1) Identify potential risks
Risk management begins with identifying the financial risks that could affect your business. You can start by analyzing the balance sheet of the company to get an overview of your liquidity, debts, interest rate risk, risk of commodity price volatility, etc. You should also review the income statement and cash flow statement to see how your results fluctuate over time.
2) Calculate the return on investment (ROI)
Assessing your return on investment gives you valuable insight into your business and financial management. This strategy minimizes your financial risks since it allows you to analyze the level of risk associated with each investment and therefore make decisions involving less risk.
3) Carry out the financial modeling of your activity
The implementation of financial modeling makes it possible to predict the financial performance of a company as well as the evolution of its financial statements. The forecasts are based on real data and take into account different hypotheses and scenarios in order to draw a realistic portrait. It allows companies to make informed decisions.
4) Diversify your risks
Financial diversification is a strategy that involves investing in different asset classes. Companies should have a diversified portfolio to reduce financial and economic risks. Organizations should invest in high-risk and low-risk assets.
5) Consult a financial expert
Cofinia specializes in financial optimization for small and medium enterprises. Our services include the creation of financial projections, the realization of financial modeling, the evaluation of investment projects as well as 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 quote!
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