Finance and Risk are two crucial issues in the world of business that cannot be over-emphasized. Finance is the heart and soul of any business; it plays an essential role from its establishment to its growth.
I’m tempted to define ‘finance’, though most of us have an idea of what one means at the mention of the word; Finance in business refers to the availability of cash or funds to meet the needs and demands of that business. Finance usually is pivotal, in most cases, to starting a business, expanding an already existing one, obtaining capital assets, developing new products, and running your business’s day-to-day operations, among many others. It is arguably the core of every business organization today.
Inarguably, finance is an essential resource for businesses to develop, maintain and subsequently operate (Cassar, 2004). Finance is a critical factor that determines the growth of a business or company in many cases (Fielding et al., 2019).
Risk, on the other hand, is a constant in every business, every business involves risks, and risk-taking is inherent in entrepreneurship and business. Risk connotes the chance of having an unexpected or adverse outcome (Chen & Kwak, 2017). In other words, the risk is the probability that some event will cause an undesirable outcome for your business. Any form of action or activity that results in a loss of any kind can be considered a risk to an enterprise or a business.
The various risks an enterprise or business can face are generally classified into business, non-business, and financial risks.
These risks are a potential threat to every business but understanding their potential impact and how to manage or mitigate them, is important for a business’s success. Financial risk is one of the risks that businesses face most because it is integral to business operations and has a substantial impact on the day-to-day activities of most businesses, and therefore could potentially result in insolvency if not properly understood and managed.
Most start-ups and smaller businesses are likely to face financial risk the most as they enter the market and adapt to market and economic conditions.
There are five main types of financial risk, being, market risk, credit risk, operational risk, liquidity risk, and legal risk; liquidity risk being a major risk that affects almost all businesses.
This means that business administrators (or managers) must evaluate the nature of finances available to them, analyse the potential risks and then calculate how such risks will impact the operations of the firm or business (Agyapong, 2020).
Financial risks can arise from the improper management of cash flowing in and out of business. Financial risk can also arise from an administrator’s inability to properly manage the company’s debt or financial obligations, which can and will affect its growth and profitability, revenue generation or cash flow, and can impose a major obstacle in the company’s future, possibly resulting in its collapse.
Some possible causes which are majorly responsible for creating financial risks for a business entity are as follows:
- The exposure to changes in the market prices, e.g. prices such as commodity costs, interest rates, inflation, and exchange rates. The volatile nature of one market may result in businesses and investors incurring losses.
- It can arise from the actions or activities of and transactions with other enterprises, including customers, and vendors.
- Internal factors or failures within the enterprise with regards to employees, processes, and systems. Internal failures in aspects such as inefficient workforce management and lower productivity can also expose a business entity to financial risks.
- Unexpected competition that may arise from the entry of arrival firms (competitors) in the market can antecedent an adverse impact on the finance of a business.
- Sudden changes in economic factors or government activities can expose business entities to financial risks. For instance, the government may introduce a policy or law (tax) that can introduce financial risk to many business enterprises.
- Seasonal issues relating to weather changes can also expose a business entity, especially those in the agricultural sector, to financial risks.
Similarly, among the common types of financial risks businesses face include:
- Credit risk
This refers to the chances of a business not fulfilling its debt obligation or failing to pay its creditors eg. bank, lender, or supplier. It can also result from giving credit to customers who also default on repayment.
- Market risk
This has to do with the probability of incurring a loss resulting from market volatility, upsurge in interest rates, cost of raw materials, and fluctuation in the exchange rate. Especially in developing countries, exchange rate depreciation tends to affect debt repayments and the competitiveness of their goods and services compared to those goods produced abroad.
- Liquidity risk
This also manifests from the business’s ability to meet its short-term financial demands or needs to run the operation of the business. This may arise from cashflow constraints resulting from the decline in revenue, low sales, or an inefficient market.
- Operational risk
This has to do with the possibility of loss resulting from the adverse effect of the policies, procedures, and systems the business entity has in place. Technical failure, fraudulent activity, and the inefficiency of workers are some examples of operational risks.
- Equity risk
This involves risks associated with the dealing of businesses or enterprises on the stock market. Poor stock market performance can be disastrous for a business that does not have the financial planning measures in place.
- Legal risk
This is any financial losses that arises as a result of legal proceedings.
- Competition risk
This risk emanates from the current competitors of the business.
- Technology risk
This type of risk involves losses incurred from damages to operating systems, acquiring technological infrastructure costs, exposure to cyberattacks or data breaches, telecommunication and connectivity issues, and data integrity.
Furthermore, financial stability is vital for a business entity to succeed, grow, and fulfil its social responsibilities. As a result, managing the risks that affect a business’s activities is important, and any staid business administrator or manager needs to guide their business against such financial risks.
Wu et al. (2014) describe risk management as the process of identifying, analysing, and alleviating uncertainty in investment decision-making. Financial risk management, therefore, attempts to deal with the uncertainties that come from the markets, which involves assessing, measuring risks, developing, and implementing strategies to mitigate the risks faced by your business entity.
I have been pondering of late on financial risk management as a critical factor in running and managing a business entity, which requires proper attention. Irrespective of whether the business is new, existing, large, or small, it is pertinent for the business managers to recognize the financial risks of the business and institute preventive measures to mitigate its impact on the business.
Financial risk management involves both qualitative and quantitative means to understand the risk faced by a firm. This consists of measuring credit, market risk, interest rate risk, liquidity, and volatility, among others. Financial risk management encompasses strategies, proper planning, and implementation of innovative practices, along with following certain guidelines to deal with the issues concerning the risk that affects the profitability of a business. Summary of the key steps involved in managing financial risk includes the following:
- Identification of the source or cause of financial risks
Identifying the risk that the business is exposed to is key in devising strategies to counter its impact. Determining if the risk is market, credit, equity, and operational risks, among others, will make it easy for it to be mitigated.
- Analysation of the impact of the financial risks on the business entity
The next step is to critically assess the severity of the risk to determine whether the business entity can withstand it or not. It requires estimating or calculating financial liquidity ratios, credit exposure, the business entity’s returns and investments, and an overall estimation of losses.
- Preparation of plans, strategies, and measures that must be implemented to counter the impact of the risks
Post measuring the severity of the risk, it is important to act on the information obtained accordingly. The manager must find an effective and efficient strategy to mitigate the risk. This decision will be contingent on data-driven results, the objectives of the business entity likewise the cost it will incur in migrating the risk. Thus, depending on the type of financial risk, strategies must be prepared by the business entity to handle the issue effectively.
- Implementation, Monitoring, and Tracking.
The next important step is to implement and enforce the strategies in accordance with the policies of the entity. Also, it is imperative to monitor the financial risk management strategies in order to assess their effectiveness. By closely monitoring and tracking implementation, adjustments can be made when necessary.
Furthermore, one of the strategies that businesses or enterprises can adopt in managing financial risk is Hedging. Hedging implies seeking assets that offset or have a weak correlation to the financial exposures of the firm. A commonly used example of hedging is insurance; insurance can help to cushion the business from a financial disaster that may occur unexpectedly. Insurance helps to protect an entity from losses that it cannot afford to replace.
Another approach a business entity can adopt to deal with the financial risk that might arise is for the business entity to create and maintain an emergency fund. An emergency fund can be used to protect an entity against unexpected financial risks. It is ideal for a business entity to have more than one emergency fund that will cater to various financial losses. For instance, having adequate savings for six months to cover up unexpected losses will be of benefit to the business.
In addition, the business entity can also diversify its investments; this can help to reduce the risk of the business. Having multiple investment portfolios can be of help in bad times. It is also important to pay attention to the development of its workforce and invest as much it can in developing its skills. The reason for this is that it makes the employees become more effective and efficient, thereby mitigating operational risk incidence.
To sum up, all that has been stated so far, as pertinent as the issues of finance and risk are to the growth and success of a business entity, so is its management. Therefore, business administrators or managers must be staid about the management of financial risks that affect their operations since the growth and profitability of the business are largely affected by these issues.
I hope you enjoyed the read. Hit me up and let’s keep the conversation going! I read all the feedback you send. Also, feel free to throw at me topics you’d like to read or hear my thoughts on. You can always head to my Calendly at calendly.com/maxwellampong or connect with me your own way through my Linktree: https://linktr.ee/themax.
Have a blessed week!
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Yang, J. S. (2017). The governance environment and innovative SMEs. Small Business Economics, 48(3), 525–541.
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Dr. Maxwell Ampong is an Investment Strategist at Maxwell Investments Group (MIG). MIG has a disciplined approach toward executing ESG-centric Sustainability Development Models, Local & International Trade of Soft Commodities, Agricultural Sector Optimisation and Market-Acquisition Strategies. He is also the Co-Founder of The RIO Corporation. He writes about trending and relevant economic topics, and general perspective pieces.