Financial Risk Management 101

Risk is part of every organization operating in today’s global marketplace. Good enterprise risk management, which contemplates strategic, business, operational, compliance, and financial risks, is essential to ensure your organization can both identify and manage any shocks, disruptions, or other negative impacts that arise. 

When it comes to financial risks, these can be among the most devastating for your cash flow and bottom line. And because the impacts of financial risk can be felt extremely rapidly, you need to be prepared to step up quickly and flexibly should you find yourself facing the reality of financial disruption. This is why a robust financial risk management process is vital.

What is financial risk?

The definition of financial risk is very simple – it’s the possibility of losing money on a business venture. But despite its simplicity, financial risk should not be taken lightly. 

Even though it’s a simple definition, it’s also quite a broad one. So financial risk is generally broken down into four primary subcategories. These are:

1. Credit risk
2. Liquidity risk
3. Operational risk
4. Market risk 

4 types of financial risk

1. Credit risk: Credit risk is the possibility that debtors of your organization won’t be able to meet their debt obligations in a timely fashion, or at all. This is one of the most common financial risks, and one that impacts all organizations whether you’re a multinational corporation or a small local business. For that reason, managing your credit risk is of the utmost importance.

2. Liquidity risk: Liquidity risk, on the other hand, is the possibility that your organization won’t have sufficient cash flow to meet its own commitments. It’s important to recognize that equity does not mean liquidity. A company may have a significant amount of equity, but if it’s unable to turn that into cash to meet expenses, it will still struggle with high liquidity risk.

3. Operational risk: Operational risk is a relatively new area in financial risk and is the risk of loss arising from failed or failing internal processes, people, and systems, or that arises from external events. This is a very broad definition that encompasses a wide array of possible risks from the small (such as minor human error) to the very large (such as fraud which leads to bankruptcy). Responding to this wide range of risk possibilities can make operational risk management tricky. 

Learn more: Operational Risk Management 101

4. Market risk: Market risk is any risk that arises due to changes within the market itself. Again, this can be the result of a wide array of factors, but generally market risk is caused by economic uncertainties which affect a large number of companies and not just a single organization. 

What is the difference between financial risk and business risk?

In general, business risk is a much broader term than financial risk. While financial risk refers to an organization’s ability to identify and manage its debt, cashflows, economic viability, and financial leverage, the financial elements of business risk refer more to the organization’s ability to generate sufficient revenue to ensure continued operations. 

Increasing global concerns about financial risk

Global concerns around financial risk are on the rise. The global economic environment is uncertain and volatile, and slower economic growth and declining margins have increased risk factors. Regulations are increasing across countries and industries, demanding more focus on strategic financial risks such as capital adequacy and liquidity. The geopolitical environment is fraught with financial impacts that may change from day to day. And fraud and cyber crimes remain on the rise. 

Organizations are having to respond to drivers of change that have never been contemplated before or that are rapidly fluctuating. This has caused organizations to consider how to enhance their ability to manage all risk – but particularly financial risk – to continue to compete in today’s environment. 

See also:

• Strategic Risk Management
• Integrated Risk Management
   

What is financial risk management?

Financial risk management is the process of protecting the economic value of an organization by managing exposure to financial risks. To do that an organization must be able to take the following steps.

Step 1: Identify potential risks and underlying causes

To identify potential financial risks within your organization, you need to first understand your own financial position. Then you can look at what risks, internal or external, could impact that position. Some elements to consider are:

• Main sources of revenue and how customer credit terms impact this 
• Cashflow history and forecasting
• Revenue growth
• Short and long-term debt and the impact interest rate changes could have
• Client or customer geopolitical segments
• International trade risks

Step 2: Analyze the risk and measure risk impacts

Once you have identified the particular financial risk, you need to determine the likelihood that it could occur, as well as the impact that it would have on the organization if it should. These are generally categorized as low, medium or high, a categorization that takes into account both the likelihood of occurrence and the level of impact. 

Categorization allows the organization to prioritize those risks in terms of both resources and management. 

Step 3: Consider opportunities to leverage new tech and tools

The changing risk environment leaves organizations vulnerable to increasing risk impacts. Forward-looking organizations must constantly consider how to leverage new technologies that are or may become available in order to both reduce costs through automation and increase responsiveness capabilities. This is no longer a “nice-to-have” step in your financial risk management, but an essential part of employing an agile approach to an increasingly complex risk environment. 

Step 4: Strategize appropriate action plans

Once you understand your risks and their impacts, you can strategize actions that can best address those risks. These actions should be designed to help you mitigate the impacts of financial disruptions and ensure that your organization can continue to meet all its financial obligations despite the disruption. To do that you will need to create controls, identify which should be applied, as well as when and how, and, of course, determine who is responsible within the organization for managing the process.  

Step 5: Create steps to monitor and report

Ongoing monitoring and reporting is a vital part of your financial risk management process. You must be able to ensure that all risk activities are being undertaken and accomplished, as well as understand where there are gaps that may leave your organization vulnerable.

Why is financial risk management important?

Financial risk management is an extremely important element of your overall risk management program. It gives organizations crucial insight into risks that could impact strategic planning, but also the viability of the organization as a whole. 

Understanding these risks also gives organizations a competitive advantage and helps to mitigate the likelihood of being negatively impacted by economic factors outside your control – particularly important in a volatile environment.