Identifying and Managing Financial Risks in Business

You're in business to make a profit.

And you want to do everything you can to ensure your business survives and thrives.

There are risks involved, and you’re well aware that if you don't know how to identify — and overcome these risks — your business may not stand the test of time.

Here, we discuss financial risks in business, how to identify them, the tools available to help manage them, and how to reduce financial risk in business.

What Is Financial Risk in Business?

Financial risk is anything that threatens your business's financial growth and profitability. 

It encompasses your business' ability to manage your debt and fulfill your financial obligations in the face of:

• Instability
• Credit
• Losses in the financial market
• Fluctuations in interest rates
• Natural disasters
• Employee turnover 

The Difference Between Business Risk and Financial Risk

Business risk refers to a business’s basic viability — whether it can generate the needed revenue to cover its operating costs and turn a profit. 

It includes your ability to cover your operating expenses, such as:

• Payroll
• Rent
• Office expenses; and 
• Production costs

Financial risk refers to whether a company can manage its financial leverage and debt, and includes:

• The costs of financing
• The amount of debt you take on to finance your business operations

What Causes Financial Risks in Business?

Why do we face financial risks in business? 

The reasons come in all shapes in sizes and may be due to: 

• Changes in the economy like inflation, recession, or fluctuations in interest rates 
• Competition
• Changes in laws, regulations, or tax policies
• Natural disasters
• Poor management
• Excessive borrowing
• Overreliance on debt
• Market volatility, including variations in currency exchange rates, and stock and commodity prices

5 Types of Financial Risks in Business

Business analysts identify at least five main types of financial risk, including:

1. Market risk
2. Credit risk
3. Liquidity risk
4. Operational risk; and 
5. Legal risk

#1: Market Risk

Market risk results from the changing conditions in the specialized marketplace where your company competes for business. 

For instance, maybe you've spent years operating a small, hometown hardware store. When a big box store opens its doors in a nearby town, your sales drop due to the expanded market and your customers’ ability to one-stop shop.

Another example of market risk is consumers' increasing tendency to shop online.

#2: Credit Risk

Also known as borrower’s risk or default risk, credit risk is the financial risk that goes along with incurring too much debt — whether it be from credit cards, bank loans, or other sources. 

Maybe you are renting your business space or have taken out a loan to purchase the equipment you need to run your business. You then are faced with a serious illness that leaves you unable to bring in the income needed to pay your rent or loan. 

If your business is highly dependent upon operating on borrowed money, credit risk is a very real concern. 

#3: Liquidity Risk

Liquidity risk occurs when you cannot turn your assets into cash.

This type of financial risk in business leaves you lacking the needed cash on hand to pay your basic expenses to keep functioning as a business.

The 1931 liquidity risk of New York's Bank of the United States is a great example. The bank lacked the liquidity it needed to repay people's deposits. This crisis resulted in the biggest bank run in American history and caused the bank to collapse under $200 million worth of debt. 

On a smaller scale, liquidity risk may simply result from a seasonal downturn in consumer purchasing or any other situation that causes you to be unable to effectively liquidate your assets and realize a profit.

#4: Operational Risk

Operational risks refer to the various risks that can arise from your company's everyday business activities. 

These may include:

• Personal issues
• Employee error or misconduct
• Mismanagement
• Technical failure 
• Cyber threats
• Lawsuits
• Fraud 

#5: Legal Risk

This type of financial risk in business arises out of negligence or the deliberate failure to comply with client obligations.

There are three types of legal risks for businesses:

1. Contract risk — This may stem from two situations: 

• Damages resulting from either party not fulfilling contract terms.
• Damages resulting from poor performance, in which the party fulfills the contract terms but provides poor service or product quality.

1. Litigation risk — This occurs when an individual or company’s action or inaction results in damages. Litigation risk generally involves a product or service. 
2. Regulatory risk — Regulatory risk occurs when a company fails to comply with federal laws and regulations. 

2 Examples of Financial Risks in Business

Example #1

In 2012, after more than 80 years on American grocery store shelves, Hostess Twinkies disappeared. 

The Hostess companies went bankrupt for the second time in ten years after many years of struggle due to a recession, the consolidation of its competitors, and the rising cost of commodities. After an attempted renegotiation of labor contracts, Hostess bakers went on strike, forcing the owners to shut down less than a week later.

While Hostess was eventually to make able to make a comeback, that is not always the case when companies are impacted so powerfully by financial risks.

Example #2

You likely remember the global financial crisis of 2008. The U.S. housing market collapsed, taking along with it several large financial institutions, many of whom had incurred a significant amount of debt. 

With the decline of the housing market, many homeowners began to default on their mortgages, leading to significant losses for these financial institutions — and contributing to the global economic recession. 

Benefits and Downsides of Financial Risk in Business

While the word “risk” may automatically create a negative connotation in your mind, when it comes down to it, financial risk can’t be labeled as either “good” or “bad.” 

Along with the cons, there are also some plus sides to having financial risks in business.

Benefits of Financial Risk

Some of the advantages of financial risk in business are that it:

• Encourages businesses to make informed decisions.
• Helps assess value (the risk-reward ratio).
• Can be identified using risk-analysis tools.

Downsides of Financial Risk

On the other hand, a few of the disadvantages of financial risk in business are that it:

• Can arise from outside forces that can't be predicted or controlled.
• May be difficult to overcome.
• Can easily spread and affect entire sectors or markets.

How To Identify Financial Risk in Business

The key to mitigating or taking the best advantage of your business’s financial risks is to identify the risks. 

Here are a few tips to help you identify the financial risks in your business:

• Consider the risks your company may face. 
• Review your corporate balance sheets.
• Study your financial statements.
• Investigate any potential weaknesses within your company’s operating plan.
• Compare your metrics to other companies in the same industry. 
• Employ statistical analysis techniques to identify your company’s areas of risk.

How To Manage Financial Risk in Business

Managing financial risks is a high priority for businesses, regardless of their size or industry.

If you want to take control of your business’s financial risks, you must:

• Identify, measure, and prioritize the risks.
• Decide how much risk you are willing to accept.
• Consider insurance to protect your business.
• Identify any potential cash flow issues. 
• Review your financial arrangements with creditors.
• Be cautious about extending credit to customers.
• Diversify your sources of income as much as possible. 
• Reassess your risks regularly.

Tools To Help Control Financial Risk

Thankfully, there are plenty of tools available to help you calculate the amount of financial risk your business is taking on.

The most common of these methods include:

1. Fundamental analysis — This is the process of evaluating your business’s assets and earnings to measure a security’s intrinsic value. 
2. Technical analysis — This involves evaluating your business’s securities by analyzing statistics and performance data, such as historical returns, trade volume, and share prices.
3. Quantitative analysis — This encompasses the evaluation of your business’s historical performance using specific financial ratio calculations.

It’s always best to analyze your business’s trends over a long period to best understand whether any fluctuations (or lack thereof) are inconsistent operating activity or progress towards a financial goal.