Financial risk refers to your business' ability to manage your debt and fulfil your financial obligations. This type of risk typically arises due to instabilities, losses in the financial market or movements in stock prices, currencies, interest rates, etc.
Difference between business risk and financial risk
Business risk relates to the basic viability of a business. It refers to your ability to turn a profit and cover your operating expenses, such as salaries, rent, production costs and office expenses.Financial risk, on the other hand, is concerned with the costs of financing and the amount of debt you incur to finance your operations.
Types of financial risk
Common categories of financial risk include:
Market risk
Market risk relates to the probability of incurring a loss due to things like market volatility, hikes in interest rates or raw material costs, fluctuation in foreign currency values, etc. For example, exchange rate changesaffecting your debt repayments and the competitiveness of your goods and services compared with those produced abroad.
Credit risk
Credit risk is the probability of failing to pay a creditor (such as a bank or a lender) or another party (eg a supplier). You may also incur credit risk by extending credit to customers, due to the possibility of them defaulting on payment.
Liquidity risk
Liquidity risk affects your ability to meet short-term financial demands to execute your business transactions. Key sources of risk are potential cashflow problems, because of things like the seasonal downturn in revenue, lack of buyers for your assets or an inefficient market.
Operational risk
Operational risk is the likelihood of incurring a loss due to the negative effects of procedures, systems or policies you have in your business. Common sources include technical failures, fraud activity, employee errors, etc. Find out more about operational risk.
Financial risk management
Managing financial risks is a high priority for businesses, irrespective of their size or industry. In order to take control of the financial risks, you need to:
- identify and measure the risks
- decide on the level of risk you are willing to accept
- consider insurance to protect against business risk
- identify potential issues with cashflow
- review your financial arrangements with creditors
- be careful if extending credit to customers
- diversify your income sources
- regularly reassess your risks
Factors affecting financial risks
Make sure to consider the various factors affecting financial risk. Broadly, these fall under two categories:
- external factors - including economic downturns, market rates, industry changes, law changes, etc
- internal factors - including underperformance, poor cashflow management, bad investments, new competition, staff issues, etc
Take into account both external and internal factors when carrying out a financial risk assessment. Find out how to evaluate business risks.
FAQs
Financial risk refers to your business' ability to manage your debt and fulfil your financial obligations. This type of risk typically arises due to instabilities, losses in the financial market or movements in stock prices, currencies, interest rates, etc.
What are the four types 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, and operational risk.
What are the top 3 financial risk? ›
Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk.
What is the best way to evaluate financial risk in business? ›
How to Conduct a Business Financial Risk Assessment and Financial Risk Analysis Examples
- Check how cash flow fluctuates over time and how your revenue growth compares to last quarter and last year. ...
- Review your short- and long-term debt. ...
- Identify any clients who represent more than 10% of your total revenues.
To begin the financial risk analysis, identify all the risk factors faced by your business. These risk factors include all aspects that affect competitiveness (costs, prices, inventory, etc.), changes in the industry to which the company belongs, government regulations, technological changes, changes in staff, etc.
What are the 7 types of bank risk? ›
These risks are: Credit, Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance, Strategic and Reputation. These categories are not mutually exclusive; any product or service may expose the bank to multiple risks.
What are the three main sources of financial risk? ›
The three main sources of financial risk mentioned in the paper are firm credit default, asset depreciation, and bank bankruptcy.
What is the biggest financial worry of most individuals? ›
Concern has consistently been highest over having enough money for retirement, with 66% worried in the latest measure. Worry about maintaining your standard of living is next, at 57%, followed by worry about paying one's normal monthly bills (42%) and paying one's rent or mortgage (37%).
What are the riskiest financial assets? ›
Stocks are generally considered to be riskier than bonds, cash alternatives and commodities. While both bonds and cash alternatives offer the investor a promised rate of return, stocks offer no such guarantee.
What is a real life example of a financial risk? ›
Financial risks are risks faced by the business in terms of handling its finances, such as defaulting on loans, debt load, or delay in delivery of goods. Other risks include external events and activities, such as natural disasters or disease breakouts leading to employee health issues.
Examples of risk measures include: range, which is the difference between the highest and lowest performance, standard deviation, which is about the degree of variation in an investment's average rate of return, and. beta, which measures an investment's volatility compared to a benchmark.
How to mitigate financial risk in a bank? ›
By spreading loans across various sectors, banks can mitigate the impact should one sector face financial difficulties. This strategy ensures that the bank's exposure to any single borrower or sector is limited, reducing the potential risk of significant losses.
What is the difference between financial risk and business risk? ›
Financial risk relates to how a company uses its financial leverage and manages its debt load. Business risk relates to whether a company can make enough in sales and revenue to cover its expenses and turn a profit. With financial risk, there is a concern that a company may default on its debt payments.
What is the formula for financial risk? ›
Risk is calculated by dividing the net profit that you estimate would result from the decision by the maximum price that could occur if the risk doesn't pan out. Compare the resulting ratio against your risk tolerance and threshold to inform your decision.
How to write a financial risk assessment? ›
Assess the likelihood (or frequency) of the risk occurring. Estimate the potential impact if the risk were to occur. Consider both quantitative and qualitative costs. Determine how the risk should be managed; decide what actions are necessary.
What are the 4 types of risks? ›
The main four types of risk are:
- strategic risk - eg a competitor coming on to the market.
- compliance and regulatory risk - eg introduction of new rules or legislation.
- financial risk - eg interest rate rise on your business loan or a non-paying customer.
- operational risk - eg the breakdown or theft of key equipment.
Four primary sources of risk affect the overall market. These include interest rate risk, equity price risk, foreign exchange risk, and commodity risk. Market risk is also known as undiversifiable or unsystematic risk because it affects all asset classes and is unpredictable.
What are the 4 risk levels in risk management? ›
Table: Risk Assessment Matrix
| E | Extremely High risk |
|---|
| H | High Risk |
| M | Moderate Risk |
| L | Low Risk |
Health risk factors are attributes, characteristics or exposures that increase the likelihood of a person for developing a disease or health disorder. Included here are four types of health factors: health behaviors, clinical care, social and economic, and physical environment factors.
