Four Simple Steps to Identify Financial Business Risk
by Scott K. Schmidt, Chief Financial Officer, U.S. Money Reserve
Risk is a necessary part of business, but it doesn’t have to stop you from being successful.
Risk is a crucial part of business, and there is simply no escaping it. Without risk, however, there is no reward. Savvy business executives and owners know how to identify financial business risks worth taking and those necessary to skip. Finding or developing an excellent risk assessment tool or system and putting it in place can help you make better decisions and better plans — and thus get a better handle on business risks. Financial business risks fall under the general business risk umbrella. Here are some identifying questions and four steps you can take to lessen financial business risks once you have identified them.
What Is a Financial Business Risk?
I’ve written about general business risks in the past, but it’s important to understand that financial business risks pose a special kind of challenge for most business executives and owners. These risks are particularly dicey because they can and often do make or break your company. As Investopedia points out, “Financial risk is the possibility of losing money on an investment or business venture.” It can incorporate a number of different types of risk, including operational risk, market risk, credit risk, and liquidity risk.
The first step to managing financial risk is identifying it. Here are the four main types of business risk and how to properly identify and mitigate them.
What Is Market Risk?
Market risk is one of the most common business risks people think of when considering financial business risk. Market risk is the risk that something in the market (economy, a worldwide pandemic, inflation, war, etc.) could negatively affect the business. Four types of market risk can negatively affect a business’s profitability. These include stock prices, interest rates, foreign exchange rates, and commodity prices.
Currently, we are in a relatively risky period thanks to the global effects of inflation. Inflation impacts businesses’ ability to purchase the goods or services they need to keep business running. Those goods and services are getting pricier by the day as inflation rises, which means that businesses can’t purchase as much as they could earlier this year when inflation was lower. Therefore, those costs have to be passed on to customers, which could create lower sales because customers don’t like to pay more for the same goods and services they previously purchased for less. Commodity prices, in particular, can significantly negatively affect the cost of building or creating your good, product, or service. For example, we all know about the chip shortage that has profoundly affected the supply and availability of new cars. The components of the chips (and the manufacturing of those chips) require commodities that come from all over the world and include everything from gold and copper to lithium and other metals. If any of those commodities becomes far pricier, chip makers will have to charge their customers more to cover those costs. It’s just the way that the integrated and global markets work.
Risk managers also have to stay on top of things like asset depreciation in property and equipment. As the IRS points out, depreciation can help business owners keep more money, which is really important in times of inflation. As Investopedia points out, inflation impacts deprecation and can be used as an advantage for a business owner.
How to Reduce Your Market Risk
There are a few ways business owners and leaders can mitigate their market risk. For one, business owners can stockpile more of their necessary components in order to build or make their products should supply issues arise later. It means buying in bulk and having the ability to store large amounts of your raw materials. It also means you need to consider the right time to buy and anticipate what the broader market (and your customers) might want and need. Ironically enough, this can be a tricky game because it requires a lot of foresight and some comfort with business risk.
You can also limit high-risk customers. Those who are late with payments or delay their shipments repeatedly are high risk since they could leave you holding the bag. It’s best to limit your number of high-risk customers or even consider requiring those with poor credit to pay for your goods and services in advance. That way, you can be sure you won’t end up upside down when it comes time to collect.
What Is Operational Risk?
Operational risk is risk that comes from inside a company. Essentially, it includes everything from HR to technology issues that can arise as a result of simply doing business and employing people. As I have written before, operational risk is often associated with human risk and human error.
Sometimes you hire bad actors. Sometimes people make genuine mistakes. The issue around operational risk is that it can run you a very pretty penny should you have to deal with it. Problems that crop up on the operational front can tie up your cash assets quickly and lead to longer-term issues.
How to Reduce Your Operational Risk
To reduce your operational risk, it pays to have a great team who is well-versed in the local and national rules and regulations you need to adhere to stay on the right side of the law. You should also leverage active prevention, as I have noted before. That means investing in the right kind of software and hardware to ensure that your business is secure and that employees are operating on the right side of the law, as well as keeping your business priorities top of mind.
What Is Credit Risk?
Credit risks are external risks that can really take a business down, especially in tough financial times like those we’re facing in the current environment. You are taking on credit risk when you extend credit to a client or customer. If that client or customer fails to pay you (or doesn’t pay you on time), you could have to tap into other resources to pay off your debts. Extending credit can over-leverage your business, but it can also help you grow and bring in potential customers. As a business executive and business owner, you need to carefully consider your risk tolerance and credit exposure based on your own criteria. There is no one-size-fits-all solution for this type of risk.
How to Reduce Your Credit Risk
To reduce your credit risk, you need to reduce your exposure to bad debt and unreliable customers. It also pays to have plenty of cash on hand so that if your customers stop paying, you have enough to cover the cost, at least for a little while.
To figure out how much cash you might need on hand, run a contingency cash flow analysis and take a close look at what your exposure might be should your customers default. Once you have that number on hand, you know exactly how much cash you should keep in your coffers to cover any potential nonpayment.
It’s also a good idea not to extend nearly as much credit to customers as you may have during more flush times. Cash is still king, and having plenty on hand will help you weather the strange days of global inflation we’re all facing.
What Is Liquidity Risk?
Have you ever had one of those moments when something goes sideways in your business, and you need immediate access to cash — fast? That’s liquidity. Liquidity risk embodies how easy or difficult it is for you to access cash quickly. It can be in the form of asset liquidity, operational cash flow, or asset sales cash flow. Your liquidity risk really depends on the type of business you’re in and what you make or sell.
How to Reduce Your Liquidity Risk
Liquidity risk really bridges the gap between internal risk (like operational risk) and external risks (like market and credit risks). The more liquid you are, the lower your liquidity risk. To reduce your liquidity risk, it’s important to have plenty of cash on hand and the right insurance in place. As I have written before, you must find a balance between your outstanding debts and your short-term liabilities to manage your liquidity risk. To find out where you stand, run a financial analysis and reduce the spread between your debt and your cash on hand. The more debt you can pay off, the better positioned you’ll be to deal with any liquidity issue that comes up.
The Bottom Line on Identifying and Managing Your Financial Risks in Business
While many of these tasks can seem overly complex, the truth is that all four of these tactics for managing your financial risks come down to having the right optics into your business’s daily, weekly, monthly, and yearly operations. It means having the right tools in place to see where your money is going, where it’s tied up, and where it’s at risk. Sometimes those tools can come in the form of technology, while other times, they can come in the form of human capital. It all depends on the sector in which you operate and how comfortable you are with managing and taking on business risk. Remember, part of being a successful business owner is taking risks. Without risk, there can be no reward. The trick is to identify and manage those risks using the four simple steps outlined above. If you follow this strategy, you’ll continue to operate well within the parameters of good business and minimize risk.