2024-01-05 09:12:18
The best companies know how to attract customers while maintaining good profits. Unfortunately, external factors and poor decisions can throw your company into financial chaos.
The good news: There is a way to reduce these obstacles by learning about financial risk and how to mitigate it.
What is financial risk?
Financial risk is the possibility that an investor or owner will lose money on a business or investment. Losses can come from lower revenues, higher costs, or both. Financial risk can also come from external factors, such as changes in the economy or political landscape (for example, pandemic-induced lockdowns).
Then there are the owners who make bad business decisions, such as:
Being highly dependent on a customer, which is a risk if that customer takes their business elsewhere. Being highly leveraged, which is a risk if interest rates rise. Investing heavily in an industry, which is risky if that industry goes through a recession.
Without a plan to reduce financial risk, your business can go downhill quickly, causing layoffs, increased debt, or default on debt payments.
Poor financial risk management not only harms your finances, but also damages your reputation among employees and potential partners or investors.
By knowing financial risk, you can make better decisions about how to grow your business and minimize the chances of financial losses.
Types of financial risk for companies
There are five types of financial risks that companies should monitor and mitigate:
Operational risk: is the risk of losing money due to errors or unforeseen events. For example, if your assembly line breaks down and you can’t produce, you will lose revenue. To mitigate operational risk, have contingency plans, such as backups for your assembly line or raw materials.
Credit risk: This is the risk that clients or borrowers will not pay you. For example, if you grant a loan to a client and they fail to make payments. To reduce credit risk, you can require customers to provide collateral or take out insurance.
Market risk: This is the risk that changes in the market will affect your business. For example, if you are a luxury handbag retailer and there is a recession, people may reduce their spending. To manage market risk, diversify your products and customer base.
Liquidity risk: This is the risk of not being able to meet your financial obligations, such as loan payments or supplier payments, because you do not have enough cash on hand. This can happen if you have too much debt or if your clients don’t pay on time. To mitigate liquidity risk, set up a line of credit or emergency fund.
Legal risk: This is the risk of being sued or held responsible for something. For example, if you are a manufacturer and your product causes an injury, you could be held liable. To minimize legal risk, take out insurance or create contracts that limit your liability.
Identification of financial risks
The first step in identifying financial risks is to understand what those risks are. Then, you can develop strategies to manage them. Here are some ways to do it:
Review your financial statements– Identify all sources of income and expenses using spreadsheets or accounting software to see where you can reduce costs (e.g. rent, utilities, inventory).
Analyze commercial debts: Look at your balance sheet. Do you have enough cash to cover operating costs? How much do you owe in debt? What type of debt (short or long term) do you have? Make sure you are up to date and not on the brink of default or asset seizure.
Identify operational weaknesses: Look at areas of your business that aren’t working well, such as slow production lines or low employee morale.
Compare metrics with those of the competition– Look at how others in your industry are doing – is there a downward trend across the board or is it just happening to you?
After identifying financial risks, it’s time to develop solutions. For example, you can decide to sell unnecessary equipment or hire more employees, if it benefits your company in the long term.
Keep in mind that some risk is good. For example, taking on a large amount of debt, such as a real estate loan to purchase a building, can help with expansion, which will help increase future income.
How to calculate financial risk
You can estimate financial risk using various formulas, depending on the type of risk you want to detect.
While an investor may want to know the company’s profit margins, an executive may be more focused on ensuring that the company’s operating costs are low.
These are the most common ratios used to calculate financial risk:
Contribution margin ratio: measures how much each sale contributes to covering fixed costs. To calculate it, take your contribution margin (sales – variable costs) and divide it by sales. The higher the contribution margin percentage, the less risky your business is.
Operating Leverage Effect (OLE) Ratio– Measures how much revenue increases or decreases based on changes in sales volume, so you can determine how much money you have left to pay non-operating costs. To calculate it, take your contribution margin and divide it by your operating margin. The higher your OLE percentage, the greater your earning potential.
Debt to equity ratio: Measures how much debt your company has compared to equity. To calculate it, take your total debt and divide it by your equity. A high debt-to-equity ratio means your business is riskier.
What is risk tolerance?
Risk tolerance is the amount of risk you are willing to take and whether you can afford the loss without closing your trades. This differs from company to company, as some people are more comfortable with risk than others.
Factors that affect risk tolerance are:
The investment industry: Volatile industries such as restaurants and food and beverage are higher risk, especially as supply chains and health concerns can shut down operations.
The age of the company: Startups are often more risk tolerant because they are trying to enter the market, while established companies may be more risk averse because they want to maintain their current position.
Your financial situation: If you are in a strong financial position, you may be more willing to take risks.
Personal preferences: Some business owners are more risk-averse than others due to their personality type or life circumstances.
When making trading decisions, consider your risk tolerance by asking yourself how much you are willing (and can afford) to lose. For example, if you are considering a new product line, evaluate the likelihood of a return on investment and whether losing this investment will affect your ability to survive financially.
If the hit will cripple your business, the risk is likely too high and the reward not worth it.
The best methods to manage financial risk
There are several ways to avoid financial risk:
Have multiple sources of income– Creates more than one income stream. If you have a laundromat, add vending machines or a service to wash, dry, fold and deliver clothes.
Create diversified portfolios– Have different investments, such as stocks, bonds, and real estate. This reduces risk because if one investment fails, the others may not.
Create a risk management plan– This is a document that describes your company’s approach to managing risks. It should include your company’s risk tolerance, policies and procedures, so everyone is on the same page.
Take out the right insurance: You shouldn’t be underinsured and have to pay out of pocket for damages, but you shouldn’t overspend on premiums either. Find the right balance for your industry.
Hire a risk management consultant: These professionals can help you identify, assess and manage risk.
Save savings for business emergencies– Set aside 6 to 12 months of income to cover business expenses during a recession, pandemic, or other unforeseen event.
Review your financial risk regularly: As your business changes, so do the risks. Review your risk management plan at least once a year to ensure it remains relevant.
Financial risk is an inherent part of doing business, but that doesn’t mean you have to accept it. Continue to evaluate your financial well-being and be innovative: There is no one way to mitigate financial risk, so get creative and see what works.
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