Financial Risk Management 101
“With great risk comes great reward.” This is a common refrain in business, one that’s especially popular with ambitious leaders looking to make big moves. For companies of any size, financial risk is a reality that owners and managers deal with daily. It may not be possible to eliminate these risks entirely, but the most successful leaders learn which chances are worth taking. Let’s discuss financial risks and explore some common risks businesses face, why they are relevant to employees, and which strategies work best to mitigate them.
What are Financial Risks?
Every business investment involves some degree of risk; it’s necessary to achieve any return or profit. For example, taking out a loan that needs to be paid back by a specific date might be considered a financial risk, even if there is a plan to repay the loan. Think of it like taking out a personal loan! If you take out a loan to purchase a car, there is some inherent risk involved in borrowing that money. Life throws curveballs sometimes, and you may encounter an unexpected medical bill, pricey house repair, or even lose your job, making those loan payments more difficult.
Businesses also face risks like this, and they’re not uncommon. Mitigating these risks however is key to maintaining a healthy financial situation.
Common Financial Risks
The first step to managing risk is understanding the most common ones a business may encounter.
Market risk is a broad descriptor that refers to any risk in your business’s marketplace.
Picture this: Two popular restaurants are operating in the same town. They serve similar clientele and feature equally appetizing menus. Suppose one restaurant decides to offer a delivery option. This decision creates market risk for the restaurant that doesn’t deliver, as they now lack the desirable service that the other restaurant offers.
Businesses that default on outstanding payments or fail to meet the terms of their contracts are classified as credit risks.
Let’s say a company identifies a supplier for parts that are essential to the products they create. If they order the parts, receive them on time, use them to make their products, but fail to pay their invoice, the business will be flagged as a credit risk. Not only does this jeopardize the existing supplier relationship, it lessens the likelihood that other suppliers will work with them in the future. They are officially a credit risk.
Liquidity risk typically refers to an organizational funding challenge. This catch-all term encompasses all the risks a business may encounter when trying to sell assets or raise funds. Anything that could prevent a company from getting cash is known as liquidity risk.
Imagine a quaint little Christmas shop. This niche store will likely have a peak season (Christmas) and a slow season (Summer). This shop will have inherent liquidity risk, as they accumulate most of their profits in one part of the year. For this company, staying operational year-round requires careful planning due to the feast-or-famine nature of their business.
Operational risk is an umbrella term that explains any risk a business might encounter just by being open for business. These risks include anything from employee turnover and lawsuits to bad budgeting decisions and fraud.
There are endless examples of operational risks. If a crucial employee quits their job at an organization, the company has an operational risk. Or, if one employee is bad at their job and consistently makes costly mistakes, the company assumes operational risk because of this as well.
Strategies to Avoid/Mitigate Risk
Unfortunately, there’s no such thing as avoiding risk completely in the business world. However, there are ways to mitigate risks. A proactive approach is critical. If you’re a business owner or a high-level decision-maker, plan ahead and know what level of risk you’re willing to accept. When making investments, consult your company leadership to see if specific risks seem feasible. Talk to experts and financial professionals to get their input. Do what it takes to ensure that the risk you’re taking is one you feel comfortable assuming — no matter the outcome.