Financial Risk: What Every Business Owner Must Know

Updated on 15 November 2022

Table of Content

Introduction

Global supply chains boost efficiency and economies of scale for organizations across all sectors. However, they also result in increasingly tangled webs of corporate relationships - and the growing financial risks that go with them.

Concerns about financial risks have been amplified across continents. In 2020, supplier financial risks accounted for around half of all the risk events that occurred. Such a setting has compelled businesses of all shapes and sizes to keep a constant eye for financial risk management models that level up performance, tick all relevant risk parameters, and improve decision-making.

What is Financial Risk?

Financial risk is the likelihood that a business will fail to settle its debt, which, in turn, could imply that the potential stakeholders will lose their money invested in the business. The more debt a company has, the greater the potential financial risk.

Case in point, US-based retailer Toys "R" Us shut down in June 2018 due to the enormous financial risk connected to debt-intensive capital structures and buyouts, intensifying the risk for investors and creditors.

Financial risk is among the prevalent concerns of businesses across industries and geographies. And because of that, the financial risk manager (FRM) examination is gaining significant traction among worldwide financial experts.

At Beroe, we believe financial appetite is the most vital risk indicator to examine and monitor. Our automated supplier financial risk ratings offer the financial integrity of global suppliers, letting businesses sense supplier disruption and safeguard the bottom line. Thanks to our quality of customer assistance, easily decipherable and accurate insights, and effective rating of suppliers on common grounds, we have become an excellent bonus to our customers’ financial risk mitigation plans.

Financial Risk vs. Business Risk

Financial risk and business risk are two major types of alarm bells that businesses, alongside stakeholders, need to look into while placing their bets.

Business risk is when a company is unable to earn enough to pay off the operational expenses. On the flip side, financial risk is when a company cannot repay the mortgage that it has borrowed to receive financial leverage.

While business risk persists as long as the firm operates, financial risk can be curtailed to a bare minimum if the company can reduce its debt and increase its equity investments in a capital structure.

Organizations can calculate business risk by the EBIT fluctuation (based on situation) and financial risk by the debt-asset ratio and financial leverage multiplier.

Business risk consists of compliance risk, reputational risk, and strategic risk. Financial risk is classified into liquidity risk, credit risk, and operational risk.

4 Types of Financial Risk

Financial risk in businesses occurs due to market shifts, which can entail a spate of factors. From observations and experiences, there are four major types of financial risks most businesses grapple with.

Operational Risk

Operational risks stem from an organization’s operational failures, such as internal mismanagement, human error, technical flaws, and inadequate employee training. Consequently, these reduce production, increase expenses and cause other ROI issues. Operational risks are specific to the organization instead of being part of a bigger industry trend.

Measuring these risks objectively is a tough nut to crack. To accurately gauge operational risks, the organization must create a record of past failures of similar sorts and then try to connect the dots between these failures.

Operational risks can be categorized into model risk and fraud risk. While the former emanates from improper model deployment, the latter occurs due to a lack of controls. Furthermore, operational risks include fraud, crime, corruption likewise, and personnel issues.

Market Risk

Market risks happen due to changing consumer sentiments or conditions in a particular marketplace where a company competes. Given the supply-demand dynamics, this kind of risk has a broader expanse.

Market risk sweeps across all the businesses in the market and not just a single firm. The sources of these risks involve volatilities in the prices of liabilities and assets.

For instance, organizations who keep pace with tech advancements enjoy a fluid revenue flow, while those who do not, lag and bear losses. Here tech advancement compels a market shift. As such, it affects every company, only a single organization.

Market risk consists of directional and non-directional risks. Directional risks happen due to shifts in interest rates, stock prices, and more, while non-directional risk can be due to several unforeseen reasons, including natural disasters and terrorist attacks.

Liquidity Risk

Financial risk management factors in an organization’s liquidity, and every business needs to assure that they have sufficient cash flow to pay off the debts. The likelihood that an organization would fail to fulfill its commitment is liquidity risk. And one of the reasons is inept cash-flow management.

Liquidity risk also considers how quickly and easily an organization can convert its assets into money to meet its expenses.

Some examples of assets that could take years (if not months) to turn into cash are real estate and bonds. As such, businesses need to check if they have existing assets to clear short-term debts or shortages.

Liquidity risk consists of two major categories: funding liquidity risk and asset liquidity risk. Asset liquidity risk arises either from insufficient sellers or buyers against buy or sell orders, respectively. On the contrary, funding liquidity risk takes into account the company’s regular cash-flow processes.

Furthermore, liquidity risks are awfully intense - in extreme cases, they force businesses to bring the curtain down on their operations.

Credit Risk

Credit risk is the possibility wherein a creditor receives a loan credit late or does not receive it at all. It relies on the debtor’s capacity to fulfill the loan payment commitment.

To manage credit risk, organizations should effectively handle their credit liabilities through sizable cash flow to their payable accounts billables, which require timely checks. Failure to adhere to the T&Cs of the loan invites adverse fines. And this can further shake the confidence of the stakeholders.

Credit risk is divided into retail credit risk, wholesale credit risk, settlement risk, and sovereign risk. Retail credit risk implies the financial pitfalls where an organization funds a start-up or individual. Wholesale credit risk arises from the organization’s investment in strategies, such as acquisitions or sales of financial assets.

Sovereign risk typically occurs due to stringent foreign exchange norms. Furthermore, settlement risk happens when one party makes the payment while the other fails to meet the commitment.

5 Tips to Manage Financial Risks

Financial risks are rapidly ranking up on the agenda throughout the hierarchy of corporate leadership due to their effects on the market valuation, bottom lines, and stakeholder value. Moreover, given the increasingly complex supply chains and the rising risk frequency, the passive approach will no longer move the needle. Instead, it requires a strategic shift (from the grassroots) in the way businesses address financial risks. Here are some sure-fire tips on how they can achieve that:

Keep a Sharp Eye on the Financials

Evaluate and understand the financial statements (cash flows, balance sheet, and profit-loss) and key performance indicators (KPI) as often as possible. This contributes to the decision-making for immediate corrective measures if the financial risks persist, as well as for marketing, strategic sales, and financial planning to pare down possible financial risks.

Dip Toes into the Investment Pool

Investing – sooner instead of later – lets businesses make their money work longer and potentially earn better returns. If investment markets showcase extreme risk, businesses begin losing money and funding, thus slashing the earned income. As such, companies can withdraw their cash from high-risk investments with minimal economic loss versus their initial investment.

One Word: Diversification

Diversification is the most critical asset in addressing financial risk as it spreads the risk among safe and risky investments in multiple economic markets. By allowing investments to have various progressions based on where the business is allocating its cash, diversification puts the ball in the court.

A common diversification technique is to divide money in a particular way. For instance, 30% in domestic stocks, 25% in low-risk money markets and government bonds each, and 20% in foreign investment instruments.

Emergency Funds are the Best Lifeline

2020 has taught everybody that no business is “pandemic-proof.” An iota of prevention - through some cash reserves - values way more than a pound of cure. So, companies must maintain an adequate cash-flow buffer. At least a tenth of the net revenue will be sufficient to weather any storm. Start-ups, in particular, must take off with a treasure chest of at least half a year worth of operating expenses (OPEX) as a safety buffer. These funds will save businesses from slipping back into the depths of economic stress during an emergency or adverse financial risks.

Leverage Financial Risk Management Solutions

If cash is king, cash management is the castle. To create success stories, businesses need to generate revenue and monitor top-line performance and expenses regularly. For this, they need the right solutions and tools. Several companies find value in AI-powered and cloud-based tools as they provide the flexibility to oversee finances anywhere, anytime.

Get Started with Beroe's Supplier Financial Risk Ratings

Surviving an environment of permanent instability and disruption, businesses across verticals tussle with extraordinary challenges regarding their financial health, evolving regulatory scenario, and overall sustainability.

Beroe’s supplier financial risk ratings help businesses assess suppliers across critical financial risk metrics and, consequently, pair with the strongest suppliers who bet on quality-focused offerings.

Our cutting-edge financial risk analytics provides risk ratings of 140 million suppliers examined by industry leader Dun and Bradstreet (D&B). Moreover, you will receive real-time notifications on select suppliers when their ratings change.

Furthermore, our solution helps you decide whether you need an instant pulse on the risk level or a deep dive into key suppliers. What is amazing is, you can purchase data points relevant to you and not the whole report. So reach out to Beroe’s expert panel and learn how we will help you proactively spot and manage financial risk across your supplier portfolio.

Financial Risk: Book Recommendations

‘The Complete Guide to Business Risk Management’ by Kit Sadgrove

Originally published in 1996, Kit Sadgrove, with this comprehensive piece, walks readers through the methods to cut through the minefield of relevant business threats. He digs deeper into critical areas, such as product quality, finance, and security, and environment.

Each section in this book is packed with valuable knowledge, practical tables and charts, and self-assessment exercises to help readers analyze the risks and stitch together a solid strategy accordingly.  A truly complete guide, the literature is a must-have for large public, corporate, and business schools or other academic libraries.

The latest iteration echoes the changes across continents, the emergence of new risks, and the impacts of macroeconomic factors on the overall business success. Moreover, Kit Sadgrove has included a brand-new spate of case studies to demonstrate his ideas in real life.

If you want to purchase only a single book on business risk management, this would be the one to go with. It has secured a rating of 4/5 on Amazon.

Check out the preview of this book here.

‘Financial Risk Management’ by Jimmy Skoglund, Wei Chen 

A masterpiece from the moguls of global banking risk management at SAS, Financial Risk Management fully equips the readers with the essentials to predict, minimize, and handle risks hanging over today’s banking space. This everyday handbook boasts the latest data and expert guidance on proper risk management, including in-depth analysis of the stress testing done by the European Banking Authority and the US Comprehensive Capital Analysis and Review.  

The book contains a holistic and integrated stack of quantitative patterns with multiple examples, adding considerable value to strategic financial risk management. It offers valuable insights into the underlying economics and ingrains readers to make risk-aware decisions.

Practice-specific conversations arm readers with the necessary tools, skills, and tactics to execute the underscored approaches to build an effective risk management posture. Moreover, the writers have included only select risk models and use cases in this time-saving manual from their own investigation across several banks.

The book is a big thumbs-up for students, researchers, and practitioners looking to deep-dive into the practical applications of financial risk management models.

Check out the preview of this book here.

‘Financial Risk Manager Handbook’ by Philippe Jorion, GARP

Risk management has been undergoing continuous evolution over the last decade and is now an integral aspect in several organizations and institutions. This 5th edition supports aspirants preparing for the Global Association of Risk Professionals’ (GARP) annual Financial Risk Manager (FRM) exam and grooms readers to analyze and manage risk in today's rapidly changing financial world.

Crafted by well-known risk management guru Philippe Jorion – alongside GARP – this definitive guidebook covers topics, including capital markets, quantitative methods, and integrated risk management. Also, it explains the legal and regulatory challenges critical to risk managers.

As the FRM exam is quintessential for risk managers worldwide, this comprehensive manual incorporates financial risk management methods and solutions essential during testing and in the physical world. The interactive CD-ROM loaded with tons of MCQs from earlier exams will prepare the readers for this holistic exam and the risk management hurdles they will encounter through their career journey.

Check out the preview of this book here.

Frequently Asked Questions

What is financial risk?

Financial risk is a situation in which a company cannot manage its loan or debt obligations, consequently bringing it to the brink of losing its capital and assets partially or fully.

What are the types of financial risks for businesses?

Businesses encounter four types of financial risks, namely operational risks, credit risks, liquidity risks, and market risks.

How to mitigate financial risks?

Organizations can bank on the following measures to alleviate financial risks in business:

  • Identify and analyze the risk
  • Develop a solid, proactive plan
  • Perform quality control tests
  • Purchase insurance (s)
  • Cut down on loans

How can businesses create a financial risk management strategy?

Businesses can implement the following tips to create a robust financial risk management strategy:

  • Regular monitoring of the cash flows
  • Diversify the investments
  • Create an emergency fund
  • Turn to tech-powered financial risk management solutions

Manage Risks to Sustain Business in Today's Dynamic World

Financial risk has always been the primary origin of risk in a supplier-buyer alliance. And supplier bankruptcy is most feared among the buyers, particularly those who do not have twin sourcing strategies and data about their supplier’s past and present. With its supplier financial risk analytics, Beroe empowers businesses with the right insights to effectively examine and oversee the existing supplier chain management with quantitative and qualitative risk parameters. For more info, check out our supplier financial risk ratings.

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