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
Market risk is a broad descriptor that refers to any risk in your business's marketplace.
Example:
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.
Credit Risk
Businesses that default on outstanding payments or fail to meet the terms of their contracts are classified as credit risks.
Example:
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
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.
Example:
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
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.
Example:
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.
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