Financial Risk: What Is It & How to Assess It

Financial risk refers to the possibility of losing money or experiencing a financial loss due to various factors. There are various risk factors can include market fluctuations, changes in interest rates, credit defaults, operational failures, or external economic conditions.

Financial risk can impact a company's profitability, cash flow, and overall financial health.

Applying an effective risk management approach can help you better understand and plan for the financial risks that can impact your business. Effective financial risk mitigation strategies help manage and minimize threats to your growth and success.

Cash flow – the money coming in via accounts receivables and going out via accounts payable – is the lifeblood of your business.  Cash flow is affected by certain financial risks, which have the potential to create sudden losses that would make it difficult or impossible for you to manage your business’s financial obligations. Those risks can include clients not paying you, changing market conditions that could affect how you conduct your business, and mismanagement or technical failures that can affect your revenue, among others.

When you perform a company financial risk assessment, you can evaluate your financial risk level from multiple angles. Basing business decisions on those findings can help reduce the possibility of these risks impacting your business.

Financial risks are those that affect your cash flow and how money is handled in the business. They can include these five major types of risk:

• Market risk refers to the ever-changing business environment and how that environment affects how you do business. Examples of market risk include how online shopping has affected traditional retail businesses and how the internet has affected print newspapers.
  
• Credit risk is the risk that comes from extending credit to a client who does not pay. This can disrupt your cash flow and reduce your profit.
• Liquidity risk refers to the inability of a company to quickly convert its assets to cash if a sudden need for cash exists. Liquidity risk also refers to a company’s inability to meet its financial obligations.
• Operational risk is the risk that operational failures. Examples of operational risks are mismanagement, fraud, business model failure or technical issues – will affect the performance of the business.
• Currency risk is the risk of unfavorable changes to the exchange rate between the operating currency and the transactional currency. Businesses diversified into foreign markets or relying heavily on the import and export of goods are most at risk.

Financial risk management means making business decisions based on your identification and analysis of the inherent risks involved. You will either accept the risks or find ways to mitigate them as part of your business investment decisions. Whether the risks are quantitative or qualitative, your goal is to strategically offset them with financial instruments or market strategies. Strategies for financial risk management include:

• Prioritizing risks in terms of severity and calculating the costs and benefits of mitigating financial risks.
• Incorporating risk accountability across the organization and training employees appropriately.
• Exercising a foreign exchange contract to hedge against currency risk.
• Implementing trade credit insurance to protect against credit risk due to customer insolvency.
• Measuring liquidity risk by analyzing financial ratios and making appropriate operational adjustments.

Financial risks are a constant in every business, and the best way to manage those risks varies from industry to industry. A financial risk assessment can help you identify the risk level specific to your business, prioritize those risks, develop ways to avoid them and outline steps to manage them should they happen. A financial risk assessment also helps you understand your appetite for risk.

To develop financial risk mitigation solutions, you will need to identify and analyze financial risks, then create a proactive financial risk management plan.

By identifying financial risks, you can take a proactive stance in protecting your business's cash flow and improving performance. To identify financial risk, start by carefully reviewing your corporate balance sheet or statement of financial position. You will want to understand what your main sources of revenue are and how customer credit terms affect this revenue. For example:

• Check how cash flow fluctuates over time and how your revenue growth compares to last quarter and last year. What has impacted growth?
• Review your short- and long-term debt. Determine what the effect would be if interest rates rise.
• Identify any clients who represent more than 10% of your total revenues. These could put you at risk if they are unable to pay their invoices. Learn more about Allianz Trade's credit insurance solutions that can protect you from this risk.
• Carefully review your client segments by geographic region. What financial risks are inherent in these regions? You can learn more about international trade risks from Allianz Trade.

Once you have identified financial risks, you can begin analyzing each risk to determine the likelihood of the risk occurring and its consequences.

First, check how consistent you are in producing profit. A healthy profit margin allows you to absorb any hits to your cash flow that you may discover in your analysis.

Then, analyze each financial risk by asking these questions:

1. What is the likelihood of this risk occurring?
2. If this risk occurs, how much of an impact would it have on the business?
3. If this risk impacts the business, what steps can the business take to recover?
4. What can the business do to prevent this risk or prepare in advance of the risk occurring?

By analyzing the risks, you can clearly see which are priorities to address, and better understand what needs to be outlined in your risk mitigation plan. Depending on your business, you should identify and analyze risks quarterly, semi-annually or annually.

Once you analyze your business’s financial risks, you can plan how to meet those challenges in cost-effective ways. Select appropriate controls that can help you mitigate identified financial risks or manage them effectively should they happen. Document the controls, identify which controls should be applied to which risks, how they should be applied and when.

Depending on when you conduct your regular risk identification and analysis exercises, you should also update your financial risk management plan.

Contact Allianz Trade for more information related to financial risk mitigation and trade credit insurance for your business.