Financial Risk Management: Definition, and Types of Risk

What Is Financial Risk Management?

Financial risk management is the practice of protecting the economic value of a company by using financial instruments to manage risks: operational risk, credit risk, and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk, sector risk, etc.

Similar to general risk management, financial risk management requires identifying its sources, measuring them, and plans to remediate them.

Financial risk management can be qualitative and quantitative. As a risk management specialization, financial risk management focuses on when and how to hedge with financial instruments in order to manage costly risks.

In the global banking sector, the Basel Accords are generally adopted by international banks for tracking, reporting, and disclosing operational, credit, and market risks.

What Is Financial Risk?

Financial risk is the possibility of losing money on an investment or a business venture. The more common and more pronounced financial risks include credit risk, liquidity risk, and operational risk.

Financial risk is one of several types of risks associated with financing, including financial transactions that involve corporate default at risk. Often it is only understood as the downside risk, i.e. the potential for financial loss and the uncertainty about its extent.

Under the general title of modern portfolio theory, science has developed around the management of market and financial risks, which was developed in 1952 by Dr. Harry Markowitz was initiated with his article “Portfolio Selection”. In modern portfolio theory, the variance (or standard deviation) of a portfolio is used as a definition of risk.

Categories of Financial Risk

There are many ways to categorize a company’s financial risks. One approach for this is provided by separating financial risk into four broad categories:

  • Market risk,
  • Credit risk,
  • Liquidity risk
  • Operational risk.

Anything related to the flow of money in and out of the company is a financial risk. Because the list of potential risks is so long, most analysts place it into one of four categories, as follows:

Market Risk

As the name suggests, market risk is any risk that arises from the market in which your company operates. For example, if you are a brick-and-mortar clothing store, the increasing tendency for customers to shop online would be a market risk. Companies that adapt to the online crowd have a better chance of survival than companies that stick to the offline business model.

In general, and regardless of the industry in which you operate, any company is at risk of being overtaken by competitors. If you don’t keep up with consumer trends and pricing requirements, you are likely to lose market share.

Credit Risk

Credit risk is the possibility that you will lose money because someone does not meet the terms of the contract. For example, if you deliver goods to customers with a 30-day grace period and the customer does not pay the invoice on time (or at all), you are taking credit risk. Companies must have adequate cash reserves to meet their liabilities or they will have serious cash flow problems.

Liquidity Risk

Also known as funding risk, this category covers all of the risks you may encounter when selling assets or raising funds. If something stands in the way of you getting cash quickly, it is classified as liquidity risk. In the case of seasonal business, for example, there can be significant liquidity bottlenecks in the off-season. Do you have enough cash to cover the potential liquidity risk? How fast can you dispose of old inventory or assets to get the money you need to keep the lights on?

Liquidity risk also includes currency risk and interest rate risk. What would happen to your cash flows if the exchange rate or interest rates suddenly changed?

Operational Risk

Operational risk is a collective term that covers all other risks that a company can encounter in day-to-day operations. Staff turnover, theft, fraud, lawsuits, unrealistic financial projections, poor budgeting, and inaccurate marketing plans can put your bottom line at risk if not anticipated and handled properly.

Financial Risk Management

How Do You Implement Financial Risk Control?

Organizations manage their financial risk in different ways. This process depends on what the company is doing, what market it is in, and the level of risk it is willing to accept. With this in mind, it is up to the business owner and directors of the company to identify and assess the risk and decide how the company will handle it.

Some of the stages in the financial risk management process are:

1. Identifying the risk exposures

Risk management begins with identifying the financial risks and their sources or causes. A good starting point is the company’s balance sheet. This provides a snapshot of the debt, liquidity, currency risk, interest rate risk, and commodity price vulnerability that the company is facing.

You should also examine the income statement and cash flow statement to see how income and cash flows fluctuate over time and what effect this has on the organization’s risk profile.

Questions to ask here include:

  • What are the main sources of revenue of the business?
  • Which customers does the company extend credit to?
  • What are the credit terms for those customers?
  • What type of debt does the company have? Short-term or long-term?
  • What would happen if interests rates were to rise?

2. Quantifying the exposure

The second step is to quantify the risks you have identified or to set a numerical value. Of course, the risk is uncertain and the number of risk exposures will never be accurate. Analysts tend to use statistical models such as the standard deviation and regression method to measure a company’s exposure to various risk factors. These tools measure the amount by which your data points differ from the average or mean.

For small businesses, computer software like Excel can help perform a simple analysis efficiently and accurately. As a general rule, the larger the standard deviation, the greater the risk associated with the data point or cash flow being quantified.

3. Making a “hedging” decision

Now that you’ve analyzed the sources of risk, you need to decide how to respond to this information. Can you live with the risk exposure? Do you need to mitigate it in any way or hedge against it? This decision is based on several factors such as the company’s objectives, its business environment, its risk appetite, and whether the cost of risk reduction justifies the risk reduction.

Generally, you might consider the following action steps:

  • Reducing cash-flow volatility.
  • Fixing interest rates on loans so you have more certainty in your financing costs.
  • Managing operating costs.
  • Managing your payment terms.
  • Putting rigorous billing and credit control procedures in place.
  • Saying farewell to customers who regularly abuse your credit terms.
  • Understanding your commodity price exposure, that is, your susceptibility to variations in the price of raw materials. If you work in the haulage industry, for example, a rise in oil prices can increase costs and reduce profits.
  • Understand your commodity price risk, which is your vulnerability to commodity price fluctuations. For example, if you work in a haulage industry, an increase in the price of oil can increase costs and reduce profits.
  • Ensure the right people are getting the right jobs with the right level of oversight to reduce the risk of fraud.
  • Carrying out due diligence on projects, for example taking into account the uncertainties associated with a partnership or a joint venture.

Who Manages Financial Risk?

The business owner and management are responsible for risk management. Only when the company grows into several departments and activities, you may want to employ a dedicated financial risk manager who controls the risk and gives recommendations for action on behalf of the company.

FAQs.

What Is Financial Risk Management?

Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to risk: operational risk, credit risk, and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk.

What is Financial Risk?

Financial risk is the possibility of losing money on an investment or business venture. Financial risk is a type of danger that can result in the loss of capital to interested parties. For governments, this can mean they are unable to control monetary policy and default on bonds or other debt issues.

What is the definition of Financial Risk?

Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of the original investment.

What are the Financial Risk Categories?

There are many ways to categorize a company’s financial risks. One approach for this is provided by separating financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.