The Top 5 Financial Risks Associated With Businesses
by Scott K. Schmidt, Chief Financial Officer at U.S. Money Reserve
There are plenty of risks in business, but how do you know which ones to tackle first?
Business and risk go hand in hand. Whether you’re taking the first step in starting your business, considering expanding, or investing in new opportunities, there are plenty of financial risks to go around.
While it may seem more comfortable to simply bury your head in the sand and look the other way, it’s essential to get a good grasp on what risks you run. Ignoring them could mean financial ruin for you and your family, not to mention the end of your business on the whole. In fact, a big part of ensuring that you properly manage your business is making sure you know what you’re risking at any one time.
Some risks can be directly managed by putting structures or plans into place inside a company. Other financial risks are genuinely outside of management’s control, but they should be accounted for and addressed as best they can. These five risks can be broken down into two larger categories: internal risks — or risks that originate inside a business — and external risks, risks that happen outside of the company, in the larger economy or world, for example. Here are the top five financial risks associated with businesses today.
Internal Financial Risks
Internal financial risks typically emanate from inside a company in one way or another, and in general, these kinds of risks are easier to mitigate right out of the gate than external risks. Internal risks are generally controllable and can even be eliminated if managed correctly. These kinds of risks can come from employees and managers, as well as breakdowns in basic operational processes. Since these are generally the easiest risks to address, they are the ones you should try to tackle first.
Operational risk is focused largely on how things get done within a company. Operational risk is generally associated with human risk or human error. Operational risk can vary from business to business, but in general, it can stem from employee or managerial mistakes or behavior that is unauthorized, illegal, inappropriate, or unethical. Most compliance and HR departments deal with this kind of risk by implementing rules and standards for all employees of a company.
If you own or run a business that largely relies on machines, robots, or artificial intelligence to create your product, device, or app, your operational risk is lower since you don’t have to rely on humans to get your widget to market. If your company relies heavily on humans to get your product, app, or device to market, then you have a higher operational risk.
An operational risk can impact your business’s financial security because this kind of risk can tie up lots of capital should something go wrong. If an employee or a manager has done something wrong, run awry of the law, or done something unethical, you could be in for a protracted legal battle that could run your financial coffers dry.
To manage and mitigate an operational risk, you should leverage active prevention. Actions, like monitoring employee’s processes or guiding people’s behavior through education and literature, are ways to reduce operational risk with human employees.
Of course, when it comes to managing operational risk, your company should have a range of tolerance for missteps. It’s not realistic to micromanage every single one of your employees and doing so could cost you from both a financial standpoint and a legal standpoint. It’s best to find a balance between what is a tolerable level of operational risk and what is not. It’s best to consult with your human resources department as well as your compliance experts to determine what the best approach is for your particular business field and your specific company.
Development risk bridges the gap between internal and external risk in many companies. This kind of risk deals with research and development, as well as the funding needed to do such things. This category of risk falls into strategic risk and is not necessarily a bad kind of risk to take on. After all, without research and development, you can’t create something new, right?
When considering a developmental risk, you have to balance the potential for high returns with the risk you are taking on. In general, when the returns are higher, the risks your company must undertake are higher. To assess this kind of risk, you need to know both what the risk entails and what the potential return could be. Generally, you should base this assessment on your industry and market knowledge, as well as your knowledge of your proprietary technologies and the people you have working on your research and development. It’s a delicate balance but taking the right kind of development risk can reap tremendous rewards.
Development risks are also known as strategy risks, and they generally cannot be mitigated by implementing rules or regulations. Essentially, when taking on a developmental risk, you need to do all you can to reduce the risk to the company and, should the worst-case scenario occur, plan to have the resources to contain the fallout.
External Financial Risks
External financial risks are much more numerous. These risks generally are out of a company’s control. They are external factors that can push a business one way or another, and the best way to mitigate most of these risks is to have a safety net in place.
Market risks are the risks of changing market conditions around the particular industry your company operates in. These can manifest in many ways, including changes in shopper behavior (i.e., most people shop online for things they once went to brick-and-mortar stores for) or a change in requirement for your product or consumer taste.
While these kinds of risks are systemic risks, and you generally have no control over them, there are things that you can do to protect yourself and your business. The best way to protect yourself from market risks is to do your best to minimize their impact. To do this, you could diversify your income stream or open up new platforms to shop.
It goes without saying that as a business owner, you should also do your best to stay up on trends and changes both in your particular industry and in industries related to what you do. Oftentimes, hindsight is 20/20, and the winds of change can be seen in other places before they impact your business. It’s best to read the news, trades, and other media to keep your finger on the pulse of what is going on both in the world and in your particular business. It also can pay dividends to think critically about how certain events, trends, and changes in the market might impact your specific business.
Credit risks are another category of external risk that businesses should consider when looking at their financials. If you extend credit to customers or vendors, you are taking on credit risk. Essentially, anyone you extend credit to could default, and you’d be left holding the financial bag.
This kind of risk can also be somewhat systemic in that credit and borrowing tend to mirror what’s happening in the broader economy. If people are pinched for income or cash flow, you can expect that accounts with outstanding balances will begin to fall into arrears.
To manage your credit risk, you must ensure that you have enough cash flow and accounts payable to cover any potential defaults on credit. The best way to protect yourself is to be prepared for a potential downturn in your business that could impact your cash flow. To do this, run a contingency cash flow analysis that looks at what you could be on the hook for should your customers fail to pay their credit accounts. That way, you know just how much cash you should have on hand for your business needs.
The other way to manage credit risk for yourself is not to overextend credit, nor take out too much credit for your business. Balancing risk and credit is a careful dance, so consult the experts in your financial department to be sure that you aren’t putting your company in a tough financial position.
Liquidity risks refer to risks that have to do with just how quickly you can access cash. Usually, this takes the form of operational cash flow or asset sales cash flow. If your company requires lots of specialized equipment or physical assets to create your product, then those machines can be sold off during times of need to generate cash. Operational cash flow refers to daily cash flow, or how much actual cash you have coming in on a day-to-day basis to float your business.
All companies have liquidity risks, but those in the financial services sector are generally more closely scrutinized thanks to the recession and banking collapse of 2008. The higher the liquidity you have, in general, the lower your liquidity risk is.
Liquidity risk is another one of those business risks that bridges the gap between internal and strategic risks and external risks. While you may have some control over liquidity risks for your business, you don’t control what the market price for a specialized piece of equipment might be should you need to sell it. Like development risk, managing liquidity risk also requires a delicate balance.
To manage your liquidity risk, you want to strike a balance between your outstanding debts and your short-term liabilities. It’s best to run a financial analysis to see where you fall on liquidity risk. Essentially you want to reduce the gap between your debt and your cash on hand. There are many ways to manage liquidity risk, but it’s best to rely on a seasoned financial expert to help businesses manage it in a comprehensive way.
The Bottom Line on Financial Risks to a Business
Running a business is inherently risky. Creating new offerings for your customers, whether you work in the B2B or B2C sector, costs money, and in order to grow a business, you need to invest. Some risks can be controlled, while others are ultimately up to the economy, governments, and state of the world. Balancing smart investment with proper leverage is a delicate dance, but if you rely on your expert financial team as you grow, you are sure to find the right way to mitigate risk for your business and ensure your long-term future growth.