Types of Financial Risk

Types of Financial Risk

All companies are exposed to some risk in their everyday operations. However, among these risks, financial risk is arguably the most concerning.

The 2021 Financial Services Data Risk report showed that in about two-thirds of companies, more than 1000 sensitive files are accessible to all employees. Moreover, 60% of companies have above 500 passwords that don't expire. Such widespread accessibility of data and a lack of expiring passwords can pose security risks to the company.

Apart from data-specific financial risks, companies face many other types of financial risks. Some include market risk, credit risk, liquidity risk, and operational risk. In this guide, you'll learn about different types of financial risks.

What are Financial Risks?

Financial risk is a type of risk that can harm a company's financial performance. It can arise from different sources and lead to severe consequences.

Financial risks can come from both internal and external sources. Internal sources include the decisions made by management, while external sources include the economic environment and market conditions.

Reasons for Financial Risks

As mentioned earlier, there are different reasons that companies face financial risks. Some of these include:

• Inadequate Management: If a company is not managed well, it can lead to financial risks. Inefficient management can result in poor decision-making, which can have a negative impact on the company's finances.
• Dependence on a Single Customer: If a company relies too much on a single customer, it can be at risk if that customer decides to stop doing business with the organization.
• High Debt: Debt is a significant source of financial risk for companies. If a company has high levels of debt, it can lead to financial problems if the organization cannot make the required payments.
• Poor Economic Conditions: The economic environment can also impact a company's financial risks. If the economy is not doing well, it can decrease demand for a company's products or services. Poor economic circumstances also lead to inflation, which may discourage customers from spending.

Changes in Government Policies: Changes in government policy can also lead to financial risks. For example, if the government imposes a new tax on a company's products, it can impact the organization's bottom line.

Types of Financial Risks

Now that you know what financial risks are and some of the reasons they occur, let's look at some of the different types of financial risks. Keep in mind that some risks might be more impactful than others, but they're all detrimental to a company.

Market Risk

Also known as systematic risk, this is the possibility that an investment will lose value due to factors that affect the market's overall performance. It involves the risk of changes in asset prices and is beyond the control of any single entity. Market risk can be further divided into two types:

• Equity Risk: It is a possibility that the stock market will fall, which can lead to a decrease in the value of stocks.
• Interest Rate Risk: When interest rates rise, it can decrease the value of bonds.

Market risk also includes the possibility of being taken out of business by competitors. Today's global market is more competitive than ever. Companies that keep up with the latest trends and make necessary changes to their value propositions tend to be more successful than those that don't make required adjustments to stand out in the market.

How to Mitigate Market Risk?

Companies can take different measures to mitigate market risk. Some of them include:

• Limiting Liabilities: Companies can protect themselves from market risk by limiting their liabilities. They can do this by issuing debt securities with a lower principal amount.
• Diversifying Investments: Companies can also diversify their investments to reduce market risk. It means investing in different types of assets, such as stocks, bonds, and real estate.

Operational Risk

Operational risk is the possibility of losses due to problems with a company's internal processes. It can arise from different sources, such as human error, system failure, or natural disasters.

How to Mitigate Operational Risk?

The most effective way to mitigate operational risk is to have adequate internal controls. These controls help to ensure that processes are carried out correctly and that risks are identified and managed effectively.

Another way to manage operational risk is to have insurance. It can protect a company from losses arising from accidents, natural disasters, or other unforeseen events. 

At Accountable, we offer all our clients who have completed the steps of compliance a $100K Accountable Compliance Protection Guarantee to cover any breach or noncompliance related costs. 

Liquidity Risk

Liquidity risk refers to the possibility that a company will not be able to meet its financial obligations when they're due. The risk can arise when a company doesn't have enough cash on hand to meet its short-term obligations or cannot convert its assets into cash quickly enough to pay its bills.

According to the WallStreet Mojo, some examples of liquidity risk include:

• Not being able to pay off short-term debt due to operational damage or exceptional losses
• Not ensuring required funding in a certain period

For instance, startups are often at a break-even risk. If they don't get subsequent funding, they may experience a liquidity risk.

How to Mitigate Liquidity Risk?

Organizations must always have sufficient cash to meet their short-term obligations. They can do this by maintaining a solid cash position and keeping a line of credit open. Another way to manage liquidity risk is to invest in assets that businesses can easily convert into cash, such as short-term investments or marketable securities.

Credit Risk

A company can also face financial risks if its customers or clients don't make timely payments. This is called credit risk.

When a customer doesn't pay on time, it can harm the company's cash flow and bottom line. To mitigate this type of risk, companies often do a credit check before extending credit to customers.

A McKinsey report showed that the Covid-19 pandemic is bound to induce credit risk for almost all industries, including consumer goods, construction, automotive, logistics, real estate, telecommunications, etc. However, the crisis-induced shock to loss and profit will differ by industry and recovery paths.

How to Mitigate Credit Risk?

Credit risk mitigations mean using certain practices to minimize the risk of losses due to nonpayment. Some examples of credit risk mitigations are:

• Thorough credit analysis of counterparties
• Diversification of the counterparty portfolio
• Having collateral agreements

Conclusion

As a business owner, you should take proactive steps to identify and mitigate financial risks. The most common financial risks are market risk, operational risk, liquidity risk, and credit risk. Although the impact can vary from one risk type to another, all financial risks can damage a company’s financial standing and inherent value. 

There are a variety of ways to mitigate financial risks. Some examples include limiting liabilities, diversifying investments, maintaining a solid cash flow, and performing extensive credit analyses of customers and clients.