Financial risk management 101
Learn about the best practices for identifying and managing financial risk within your organisation.
What is financial risk?
Risk is part of every organisation operating in today’s global marketplace. Good enterprise risk management, which contemplates strategic, business, operational, compliance, and financial risks, is essential to ensure your organisation can both identify and manage any shocks, disruptions, or other negative impacts that arise.
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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.​​​
Definition of 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.
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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:
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Credit risk
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Liquidity risk
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Operational risk
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Market risk
Four types of financial risk
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Credit risk
Credit risk is the possibility that debtors of your organisation 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 organisations whether you’re a multinational corporation or a small local business. For that reason, managing your credit risk is of the utmost importance.
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Liquidity risk
Liquidity risk, on the other hand, is the possibility that your organisation won’t have sufficient cash flow to meet its own commitments. It’s important to recognise 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.
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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.
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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 organisation.
Financial vs business risk: How are they different?
In general, business risk is a much broader term than financial risk.
While financial risk refers to an organisation’s ability to identify and manage its debt, cashflows, economic viability, and financial leverage, the financial elements of business risk refer more to the organisation’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.
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Organisations are having to respond to drivers of change that have never been contemplated before or that are rapidly fluctuating. This has caused organisations to consider how to enhance their ability to manage all risk – but particularly financial risk – to continue to compete in today’s environment.
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See also:
What is financial risk management?
Financial risk management is the process of protecting the economic value of an organisation by managing exposure to financial risks. To do that an organisation must be able to take the following steps:
Step 4: Monitor and review risk management
strategies
Step 1: Identify potential risks and underlying causes
To identify potential financial risks within your organisation, 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:
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Main sources of revenue and how customer credit terms impact them
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Cashflow history and forecasting
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Revenue growth
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Short and long-term debt and the impact interest rate changes could have
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Client or customer geopolitical segments
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International trade risks
Risk management is an ongoing process. Regularly review and monitor your risk management strategies to ensure they remain effective. This involves:
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Tracking risk indicators: Keep an eye on key financial and operational metrics that signal changes in risk levels.
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Reassessing risks: Periodically revisit and update your risk assessments to reflect changes in the external environment or internal operations.
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Adjusting strategies: Modify risk mitigation strategies as needed based on performance evaluations and emerging risks.
Step 5: Communicate and report
Step 2: Assess the impact and likelihood of identified risks
Effective communication is crucial for successful risk management. Ensure that all relevant stakeholders are informed about the risks and the measures in place to address them. Regularly report on risk management activities and outcomes to maintain transparency and support informed decision-making.
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Once potential risks are identified, evaluate their potential impact and the likelihood of their occurrence. This involves quantifying how these risks could affect your organisation’s financial health. Use software tools that include risk matrices and/or scoring systems to prioritise risks based on their severity and probability.
Step 3: Develop and implement risk mitigation strategies
After assessing risks, develop strategies to mitigate them. These strategies might include:
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Hedging: Use financial instruments to offset potential losses from fluctuations in currency or interest rates.
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Diversification: Spread investments and revenue sources across different areas to reduce dependence on any single source.
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Insurance: Obtain appropriate insurance to protect against specific risks, such as property damage or liability claims.
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Operational adjustments: Implement changes in business processes or operations to minimise risk exposure, such as improving cash flow management or renegotiating customer credit terms.
Why is financial risk management important?
Prioritising financial risk management
is essential
Financial risk management is crucial for safeguarding an organisation's economic stability and achieving long-term success. Effective financial risk management helps identify, assess, and mitigate potential threats that could jeopardise an organisation’s financial health.
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By proactively managing risks, organisations can prevent significant financial losses, ensure regulatory compliance, and maintain investor confidence. Furthermore, sound financial risk management supports strategic decision-making, enhances operational efficiency, and helps organisations navigate uncertainties in a volatile market. Ultimately, prioritising financial risk management is essential for maintaining a resilient and robust financial position.
