Financial risk is often unavoidable in business. Sometimes, it’s even acknowledged as anecessary condition to achieve a desired return. This paradox highlights the diversity offinancial risks and their sources and underscores the need for business leaders tounderstand the financial risks inherent in their companies, no matter the size. Evencompanies with the most thoughtful, strategic business leaders encounter influences beyondtheir control — think macroeconomic shifts and political unrest — makingidentifying and preparing for the more foreseeable risks even more critical. This articleidentifies 10 common types of business risk and 15 ways to minimize them.
What Is Financial Risk for Companies?
Financial risk is a broad term for situations that can lead to an adverse commercial impact,such as reduced profitability, loss of capital, strained cash flow and possibly businessclosure. Risk and reward tend to have a direct correlation — the greater the potentialrisk, the bigger the potential payoff. However, unlike high-stakes gamblers, businessleaders have a fiduciary responsibility to protect their company and its constituentsagainst overexposure to financial risk.
That list of undesirable outcomes can be especially concerning when one considers thesignificant number and variety of financial risks, including credit risk, market risk andfraud, to name a few. This is where risk management comes into the picture. Risk managementis the preventative approach to mitigating financial risks. It’s a combination ofidentifying, monitoring, controlling (where possible) and planning for potential risks tocurtail their impact. Vigilance and preparation are key. Vigilance includes establishing andmonitoring various internal and external indicators that can raise or lower risk.Preparation refers to developing strategies to avoid or lessen risks that carry thepotential for losses, including, but not limited to, carrying various types of insurancepolicies.
Key Takeaways
- Financial risk is unavoidable but can be mitigated with careful planning and the righttools.
- Different types of financial risk come from external sources, endemic factors andinternal processes.
- High-quality, accurate data is fundamental to risk management.
- Explore 15 ways to avoid, reduce, transfer or accept financial risk.
Types of Financial Risks
The first step in creating an effective financial risk mitigation plan is to identify thetypes of risks that could impact a business. Some types of risks are more pertinent thanothers, depending on the industry, the size of the company and other operational factors.Understanding the specific nuances of how these risks could impact a business allows forbetter planning and more effective mitigation. Ten common types of financial risk are:
Credit risk
Market risk
Competitive risk
Liquidity risk
Cash flow risk
Growth risk
Leverage risk
Global risk
Errors
Fraud
Extending credit to customers is a standard practice in many industries, and it can be auseful way to expand a business’s customer base and increase revenue. Butextending credit also introduces a higher potential for uncollected sales. Whencustomers don’t pay, the seller’s business loses revenue and has unrecoupedcosts for products or services delivered. And if a business has only a small number ofcustomers, extending credit exposes it to even more credit risk if one of thosecustomers experiences cash flow problems or goes out of business.
Market risk for business refers to the external forces endemic to a company’sspecific industry. Evolving customer preferences, advancements in technology and otherdisruptors can cause an industry to morph and change, requiring businesses toadapt to survive. Consider the evolution in the recorded music industry from vinylalbums, to cassettes, to CDs, to digital streaming. Market risks are often out ofmanagement’s control.
The performance of other companies in a business’s market creates competitive risk.Moves by existing competitors that provide comparable goods or services can upset abusiness’s sales and cash inflows, for example, by changing prices, productfeatures or distribution strategies. In addition, new competitors can emerge to vie forthe same customers’ attention and budgets by fulfilling their needs in differentways. A good example is how entertainment streaming services introduced competitive riskto movie theaters.
A company’s liquidity refers to its ability topay its current obligations using short-term assets, such as cash, accounts receivableand short-term investments. Liquidity can be thought of as a more specific and immediateform of cash flow. Liquidity risk is usually a matter of timing — ensuring thatcash flow or the ability to convert assets to cash quickly is adequate to make timelypayments on debt. Liquidity risk is higher when timing is out of sync or capital islocked up in long-term assets. An equipment-heavy construction business that must payfor building supplies in advance of cash collections would have higher liquidity riskthan a cash-and-carry retail grocery store, for example.
Cash flow risk refers to the potential imbalance between all cash inflows andoutflows. It involves the ability (or inability) to pay immediate and medium-and long-term obligations on a constant basis and is often impacted by systemic cashmanagement policies. For example, periods of negative cash flow — when outflowsare greater than inflows — can be overcome, but consistent negative cash flow isusually unsustainable. Consider the cash flow risk for a business that extends 120 daysof credit to its customers but is subject to 60-day payment terms from its suppliers.
Business growth is typically viewed as a positive trend, but companies should be aware ofpotential risks. For one, overextension of capital to invest in expansion can causeliquidity issues. Second, stress on operational infrastructure can cause breakdowns inequipment, distribution interruptions or employee burnout, all of which can have fiscalconsequences. Third, a business’s reputation or its product’s brand imagecan be impaired by poorly planned or executed growth, causing long-term financialproblems. And last, even the best forecastsand projections for new business development contain estimates with varyingdegrees of accuracy.
Leverage refers to the amount of borrowed capital a business uses to finance itsoperations or new investments. Leverage risk refers to the potential for the cost ofthese borrowings to become prohibitive or greater than the return on the underlyinginvestment. Rising interest rates and lower-than-expected returns are variables thatincrease leverage risk. Another sort of leverage risk exists when a business maxes outit* available credit and is unable to access additional funds in the event ofemergencies or revenue downturns.
In the interconnected global economy, businesses of all sizes encounter a level of globalrisk; it’s not just reserved for large international conglomerates. Global riskstems from changes in government policy, exchange rates, foreign country economies,social unrest, cybersecurity threats, public health and many other factors. Bringingthese issues closer to home, consider the global risk inherent in direct supplysourcing, such as shortages or price changes on parts imported from anothercountry. Indirect supply chain issues are another example, such as the inability topurchase delivery trucks due to international chip shortages. Both examples ultimatelyhave an impact on a business’s sales and profitability.
Business leaders rely on accurate information to make well-informed decisions. Inaddition to running their everyday business, they need good data to identify and monitorbusiness risks. Errors in anyof this information increase the likelihood of sub-par decision-making andfinancial loss.
Fraud is a real risk to most businesses. The potential for theft, embezzlement orcybersecurity breaches can come from both internal and external sources. Fraud causesdirect financial loss, such as revenue skimming and asset loss, and can raise otherrisks, including reputation, compliance and legal risks with indirect financialconsequences.
15 Ways to Mitigate Financial Risk
By identifying and monitoring risks, a company is better positioned to mitigate theirfinancial impact. The four approaches to mitigating financial risk are avoidance, reduction,transference and acceptance. Avoidance involves changing course to dodge the factors thatcause the financial risk. Reduction takes the approach of managing through the risk but withmeasures to minimize its effects. Transference means off-loading or sharing some of the riskwith other parties, such as business partners or insurance agencies. Finally, acceptance isthe decision to move forward, accepting the potential consequences of the risk rather thantaking action to mitigate or avoid it. Businesses may choose a particular approach based onthe type of financial risk involved or they may opt to combine multiple approaches toaddress a risk. The 15 ways to mitigate financial risk listed here draw on all fourapproaches.
Carry insurance
Evaluate efficiency
Maintain emergency funds
Invest in quality assurance (QA)
Diversify business investments
Keep accounts receivable (AR) low
Read the fine print
Reduce unneeded debt
Maintain quality records
Create a cash management strategy
Invest in employees
Outsource when it makes sense
Focus on metrics for decisions
Leverage financial technology
Establish separation of duties
Insurance is a way to transfer some financial risk to a third party. It comes in handywhen paying for an unexpected loss, thereby preserving company capital. However, keep inmind that insurance policies carry premium costs, and while the proceeds of a claim canhelp finance recovery, they don’t eliminate the risk or the disruption. There aredozens of business insurance policies covering all kinds of financial risks, includingproduct liability, crime, commercial property claims, workers compensation, businessinterruption and cybercrime.
By maximizing operationalefficiency a business can unlock cash flow that can be redirected to cover theimpact of financial risk. Additionally, the process of continually evaluating aspects ofa business can help identify potential business risks.
Establishing cash reserves is a way to prepare for the impact of financial risks. Alongwith insurance, emergency funds can helplessen financial losses and keep a business running. Emergency funds can be internallygenerated through positive cash flow or they can be in the form of an accessible line ofcredit. Preplanning is necessary in both cases.
Instituting strong QA measures to make sure that products and services meet desiredquality standards is a way to reduce product-related financial risks. Checklists,checkpoints, sampling and supervision throughout the production process can help ensurebetter outcomes.
Diversification is a way to spread risk across multiple areas. When businesses holdinvestments in other companies through stocks or ownership stakes, selecting a varietyof industries helps minimize the risk that investments all rise and fall together.Further, diversifying investments between equity and debt can help minimize volatilityand risk. Similarly, diversifying a business’s income streams, so as not to relyon a small number of products or customers, is another way to hedge financial loss andminimize risk.
As AR balancesage, collection becomes less likely. Uncollected AR results in lost revenue,reduced cash flow and lost profits, so it’s important to stay on top of thebalances by using an AR aging report, which tracks the payment status of acompany’s AR, or other similar tools. Additionally, AR vigilance can uncovercustomers that present credit risks so future sales terms can be adjusted to preventfuture losses.
Misunderstandings among commercial partners can cause all sorts of problems that canresult in financial loss. Documenting agreements in writing helps reduce ambiguity andthe likelihood of financial loss, especially when it comes to the finer details of anarrangement.
Most businesses rely on loans from time to time to support gaps in cash flow and forlong-term investments. However, it’s important to manage leverage risk by keepingloan balances as low as possible to avoid excess borrowing costs, such as interestcharges and bank fees, as well as heavy cash flow drains from inflated loan payments.Additionally, lower outstanding loan balances can maximize a company’s availablecredit for emergencies and unforeseen challenges and opportunities.
Keeping quality records is fundamental to managing financial risk because it providesclean data for historical analysis and future visibility. It’s also a primary wayto avoid compliance risk. Businesses have many reporting requirements from lenders,government agencies, industry regulators and shareholders to prove they are meetingregulations and abiding by the law. Non-compliance results in direct penalties andindirect reputational risk. Sloppy record-keeping increases the risk of baddecision-making and non-compliance, making maintaining quality records table stakes.
Running out of cash is one of the most common reasons that businesses fail. Creating a cash managementstrategy helps reduce financial risks through planning and prevention.Forecasting cash inflows and outflows, monitoring AR and accounts payable balances,managing debt payments, keeping an eye on currency exchange and interest rates andstaying close to market demand all play a part in developing a cash management strategyand can help lower risk.
Employees can have a big impact on the success or failure of a business. This isespecially evident in services industries, but it’s also a factor that affectsproductivity in non-services industries. Because there is a direct correlation betweenthe adequacy of employee training and businessoutput, investing in employees reduces the risk of costly errors that can damage acompany’s reputation.
Outsourcing certain functions is one way to mitigate certain financial risks by savingtime and money. Hiring third-party specialists to handle certain parts of a business canbring cost savings, thanks to the service provider’s economies of scale.Outsourcing can also save time because expertise is already in place. Financial risk isshared between the company and the service provider, and cost savings can be used toreduce risk in other areas of the business. Beware, though, that while outsourcing canreduce some financial risks, it may introduce others, so it’s important toevaluate where it makes sense.
Consider the adage, “You can’t manage what you don’t measure.”Using objective metricshelps lower financial risks by supporting impartial decision-making and helpingleadership stay focused on tangible goals. Planning, measuring and using standardized,quality information can help keep a business on track and provide early warning ifit’s not. Impulsive or under-informed decisions tend to increase the level ofrisk.
The right financial technology can bolster the other tactics for minimizing financialrisk. Robust technology, such as cloud-based accounting software and integrated enterprise resource planning (ERP) systems, isessential for identifying and analyzing trends that might become risks — oropportunities. Financial technology is useful for planning and developing metrics andreduces the potential for manual errors in record-keeping.
A strong internal control environment helps reduce the risk of errors and fraud. Theinternal control environment is a network of processes designed to catch anomaliesbefore they happen (prevent controls) and to detect them if they do happen (detectcontrols). Segregation of duties is a primary control that works by ensuring that nosingle person has full control of a single transaction, usually by separating functionslike recording, approving, paying and reconciling. Segregation of duties can be achallenge for small organizations but can be assisted by the right technology.
Mitigate Financial Risks With NetSuite Financial Management Software
The 15 ways to minimize financial risks outlined in this article share a common need foraccurate, detailed and reliable financial information. NetSuite financial management solutions canhelp with managing financial risks, from planning to monitoring. The solution’sfinancial, headcount and operational data is essential for risk management planning. Itsdashboards, alerts and real-time visibility can help monitor risk metrics for earlyintervention. And access controls and an automated workflow provide strong internal controlsfor accurate data and reduced risk of fraud.
Businesses can’t eliminate all financial risks, but they can actively manage theirrisk/reward dynamic. Understanding, monitoring and mitigating financial risks are essentialsteps to maximize a business’s success. Minimizing financial risks means having plansand processes in place to reduce, share or avoid potential loss of profitability or capital,strained cash flow and business closure. The 15 approaches discussed above can help minimizefinancial risks, including credit, liquidity, leverage, market and growth risks, amongothers. Access to high-quality, current data to support planning and decision-making isfoundational.
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Financial Risk Mitigation FAQs
Why is it important to manage financial risks?
Financial risk is a broad term for situations that can lead to an adverse commercial impact,such as reduced profitability, loss of capital, strained cash flow and possibly businessclosure. While businesses can’t eliminate all financial risks, they can activelymanage their risk/reward dynamic by understanding, monitoring and mitigating those risks.
How do you identify financial risks?
The first step in creating a financial risk mitigation plan is to identify the types of risksthat could impact a business. Some types of risks are more relevant than others, dependingon the industry, the size of the company and other operational factors. Reviewing abusiness’s financial reporting, such as balance sheet, income statement and cash flow,can highlight areas of risk. Comparing those reports over time identifies trends that may beheading in a risky direction.
What is an example of financial risk management?
There are four approaches to financial risk management: avoidance, reduction, transferenceand acceptance. Avoidance, for instance, involves changing course to dodge the factors thatcause the financial risk. Carrying insurance is an example of financial risk management thattransfers some financial risk to a third party.
What are the best ways to minimize financial risk when starting abusiness?
Entrepreneurs need to consider financial risks in the same ways that established businessesdo. This includes being diligent with contracts, carrying insurance, investing in employees,developing metrics and outsourcing when it makes sense. It’s helpful to establishquality records by leveraging financial technology from the outset. As new businesses grow,they can work to mitigate financial risks by evaluating efficiency, investing in qualityassurance, keeping accounts receivable low and using separation of duties where possible.Nonetheless, since cash flow is a primary financial risk when starting a business,it’s important to maintain emergency funds, diversify investments and keep debtbalances as low as possible as part of a formal cash management strategy.
What methods do you use to minimize risk?
There are four approaches to mitigating financial risk: avoidance, reduction, transferenceand acceptance. Fifteen examples of ways to minimize financial risk are:
- Carry insurance.
- Evaluate efficiency.
- Maintain emergency funds.
- Invest in quality assurance (QA).
- Diversify business investments.
- Keep accounts receivable (AR) low.
- Read the fine print.
- Reduce unneeded debt.
- Maintain quality records.
- Create a cash management strategy.
- Invest in employees.
- Outsource when it makes sense.
- Focus on metrics for decisions.
- Leverage financial technology.
- Establish separation of duties.
