Financial risk is the potential for loss or negative outcomes due to situations that are not under your control. These can include market fluctuations, liquidity risks or other factors that influence your business.
There are different types of financial risks in business, each with its own pros and cons. Let’s take a look at some of the main types.
Credit risk is the possibility of a financial loss when a borrower fails to pay principal and interest on debt. Any business that extends credit to customers in some way is susceptible to this type of risk, including banks, mortgage providers, credit card companies and utilities.
In general, lenders go to great lengths to assess a borrower’s ability to repay their loan according to its original terms. This process is known as ‘underwriting’ and involves looking at the five Cs: credit history, capacity to repay, capital, conditions of the loan and collateral associated with it. Credit risks can also stem from the concentration of a loan book within a certain industry or country, which is called country risk.
For example, if a financial institution relies heavily on lending to clients in the oil and gas industry, it is vulnerable to this specific risk. If the industry suffers a major setback, the financial institution could lose massive amounts of money and become less attractive to investors. This can cause the bank’s credit rating to fall, which in turn leads to lower operational efficiency and less scope for growth. Fortunately, there are numerous resources available for businesses to help manage their credit risk. These include credit scoring and monitoring services offered by leading business credit bureaus such as Dun & Bradstreet.
Market risk is the chance of losing money due to factors that affect the performance of financial markets. This type of risk is also referred to as systematic risk since it affects the entire market simultaneously and cannot be eliminated through diversification. It consists of four major types: interest rate risk, commodity risk, currency risk and country risk.
Interest rate risk is the possibility that the value of fixed-income investments like bonds will decline. This risk is influenced by monetary policy decisions of central banks and inflation expectations. Commodity risk is the possibility that the price of staple products like crude oil and corn will fluctuate. Currency risk is the possibility that the value of a currency will increase or decrease. Country risk is the risk that a country will experience political instability, natural disasters or other factors that could impact the economy and therefore affect investment opportunities.
Market risk is measured using a variety of methods including the Value at Risk (VaR) modeling method. VaR is a statistical risk management tool that calculates the potential loss of an instrument based on its underlying risk factors, such as liquidity, credit spreads and exchange rates. Banks will also include sensitivity in their calculation of market risk capital requirements which is the amount of change in an instrument’s current value resulting from a small change in its underlying risks.
While financial risks are a normal part of doing business, they can be damaging if not mitigated properly. Luckily, there are several ways to avoid the effects of financial risk.
The most obvious way to avoid the impact of financial risk is by having enough cash on hand. A company with plenty of liquidity will be able to meet its short-term debt obligations without problems.
Companies often measure their liquid assets through the current ratio, which compares the amount of current assets (including accounts receivable) and inventory to the amount of current liabilities. Other metrics, like the quick ratio or acid test, are less conservative as they only include highly liquid assets such as marketable securities and cash.
One of the main sources of financial risk for a company is its inability to sell assets at a fair price. This can occur when a company holds onto illiquid assets such as factory or office space, IT systems and equipment, which may take months to sell in a downturn.
Having a strong understanding of these types of financial risk can help a company minimize its exposure and stay competitive in the marketplace. Companies must be able to identify the warning signs of potential liquidity crises and respond quickly to prevent them from turning into disasters. A good example is the recent bankruptcy of Toys “R” Us, which closed its stores after being unable to pay its debts due to poor sales in the wake of changing consumer trends.
Financial disruption risk is a business’s vulnerability to a change in its industry or marketplace. It may occur due to factors out of the company’s control, such as global market shifts or natural disasters. When this happens, it could negatively affect the company’s revenue and cause it to lose profit.
Liquidity risk refers to a business’s ability to repay its debts with income. It can arise from several sources including low cash flow, reduced sales and high interest rates. This type of risk is often linked to a lack of internal controls and an inability to predict future business trends.
Market risk is a common type of financial risk in business. It can affect companies in the same sector and is caused by fluctuations in the market, such as stock prices, currencies and interest rates. The 2007 – 2008 global financial crisis is a good example of market risk. Several businesses closed, investors lost fortunes and the government was forced to rethink its monetary policy.
There are also operational risks, such as mismanagement or a lack of staff training, which can lead to a reduction in production and cost the company money. These types of risks are more specific to each individual business and can be difficult to measure objectively. For instance, in 2018, Toys “R” Us liquidated its stores due to declining sales and dwindling liquidity.