There are various financial risks, and they can originate from the following sources. Now, let’s understand the major ones that a company may face:
1. Market risks
This is the chance of losses from market changes in finance such as interest and currency rates changes, commodity prices, and market indices.
Example: a firm exporting its commodities to other countries faces the exchange rate risk.
The interest or returns in foreign currency might come down when sold back to the local currency if the foreign currency is depreciating relative to the local currency.
2. Credit risks
It relates to the probability of default by debtors or counterparties, resulting in financial losses for those granting credit.
When a company sells on credit, it runs the risk of not receiving payment, which can directly impact its cash flow.
Example: a bank that lends money to customers is subject to the risk of default.
3. Operational risks
It arises from failures in internal processes, systems, human resources, external events, among others. It may include fraud, operational errors and unpredictable events.
Example: an e-commerce faces operational risks related to failures in its online payment system.
If the process of payment is disrupted, the company will have lost revenue and possible reputational damage.
4. Liquidity Risks
You will find it challenging to sell the assets or have enough cash to meet your financial obligations, thus resulting in cash flow problems.
If the company cannot readily transform its assets into cash, then it may face financial distress.
Example: an investment fund may have investment assets that are quite illiquid in the short term and, therefore, it is vulnerable to liquidity risk.
In a situation where there are many investors presenting redemption requests simultaneously to redeem shares, the ability of the fund to meet those requests would be challenged.
5. Legal risks
It arises from changes in legislation and regulations, as well as legal disputes. Failure to comply with legal standards can result in penalties and financial impacts.
Example: A financial institution that fails to comply with anti-money laundering regulations may face legal penalties and substantial fines.
6. Political risks
Related to political changes that adversely may affect business, investment, or operational conditions within a given region or country.
For example, an energy firm operating in a country with polititical instability may face political risks that prevent it from carrying out its operations and activities and maximize revenues.
7. Modeling risks
This is the case when the financial models, which are designed to predict events and make different choices, fail to reflect the reality. Therefore, this leads to false decision-making.
Example: A financial institution that uses models to price derivative products may face risks if these models do not adequately capture market volatility, leading to mispricing .
How to avoid financial risk?
Now that we understand the types of risks and how to identify them, let’s talk about how to avoid them through some methods, such as market (sociocultural) research and mathematical calculation methodologies, which can help predict the probability of a risk or not.
Calculations are performed based on hypothetical scenarios, that is, they are conducted based on ideas, but they usually provide security and accuracy when the calculation is done correctly.
Importing companies, for example, are subject to market risk and, when calculating a possible scenario of losses and damages in a hypothetical situation, where the dollar is high, the company can incorporate defense measures such as exchange rate protection strategies and ensure a more predictable financial flow.
Furthermore, consider:
- Investment diversification: Do not keep all your eggs in one basket. Both investment and sources of income can be diversified to reduce impacts from a risk such as the market;
- Strict credit policy: defines specific standards to be applied in granting credit and quantitative limitations regarding the credit to be granted, especially on new customers
- Insurance and warranties: Utilize insurance to protect your business against certain risks, such as theft, fire, or natural disasters. Warranties under commercial contracts also apply;
- Automation and technology: implementing technological solutions can help reduce human errors and increase process efficiency, minimizing operational risks;
- Strict cash management: Maintaining strict control over cash flow is essential to avoid liquidity problems. Always plan ahead and maintain financial reserves for emergencies.
How to perform risk management in financial management?
Here are the steps and strategies one can use:
1. Risk identification
Clearly analyze the different kinds of risks an organization faces financially, including market risks and operational ones, among others.
Conduct interviews with stakeholders, research historic records that have happened previously, and examine internal operations in a bid to identify threats.
Tools for identification:
- SWOT Analysis (Strengths, Weaknesses, Opportunities and Threats): helps identify internal and external factors that may impact the company;
- Process Mapping: used to evaluate each stage of internal processes to identify points of vulnerability.
2. Risk mitigation
It should develop risk mitigation or reduction strategies. This may include diversification of investments, internal controls being more effective, some form of hedging, and many more.
It must establish a plan of contingency to cope with unforeseen risks and adverse events.
Common mitigation strategies:
- Diversification: distribute investments and revenue sources to reduce dependence on a single cash flow;
- Hedging: The practice of using financial instruments as means of hedging against risks arising from market fluctuations, such as exchange rates or commodity price fluctuations;
- Insurance: buying insurance policies that will cover particular risks such as theft, fire or any possible natural disasters;
- Internal controls: policy and procedure implementation for fraud prevention and error reduction.
3. Continuous monitoring
- Implement continuous monitoring systems to track risks over time;
- Include an economic feasibility study ;
- Regularly update the risk assessment to reflect changes in market conditions, regulations and internal operations;
This monitoring helps to preserve your company’s image risk , avoiding headaches.
Monitoring tools:
- Performance indicators: Monitor critical areas using KPIs (Key Performance Indicators) to find early warning signs.
- Regular audits – internal and external checks to ensure that controls are in place and followed accordingly and that risks are being managed appropriately.
- Review scenario: review and upgrade the risk scenarios continuously with respect to internal and external environment changes.
4. ERP system
ERP systems provide an integrated and efficient approach, centralizing financial data, facilitating the comprehensive analysis of risk-related information in different areas of the organization.
They also automate financial processes, which help reduce errors in operation and improve efficiency, thus reducing operational risks.
They offer reports in real time, thus enabling managers and decision makers to have access to critical information on time with regards to risk management.
They have specific modules on risk management, particularly on the integration of risk assessment, monitoring, and reporting into a single environment.