Financial risk is the possibility of losing money from business or investments. There are five major types of financial risk. These include market risk, credit risk, liquidity risk, operational risk and inflation risk. Understanding, assessing and employing smart strategies to mitigate risk are key to a successful financial future.
Whether you’re an individual, family or business, learning to weigh and manage risk is an integral part of making prudent financial decisions. In fact, if you’re going to try and build wealth in any way, you’re going to take on financial risk. This might be the risk of investing in public companies, which could fail. Or it may be the risk of getting a business loan to buy additional assets so you can expand your business operations—that could ultimately go under.
If you’re going to succeed financially, you need to know how to assess and manage financial risk both as a consumer and a business owner. In this article, we’ll explain financial risk, how you can assess it and strategies you can use to mitigate it.
What Is Financial Risk?
Financial risk is roughly defined as the potential for a person or business to lose money from an investment or business venture.
For individuals, financial risk is commonly seen in the stock market when investing in public companies. Any company you invest in has the potential to have its stock value drop in price, whether due to internal or external factors.
For businesses, financial risk is usually seen in the form of cash flow issues. If they have problems making enough money, they may not have enough funds to cover their financial obligations. These could include credit card payments or business loan installments.
Financial risk does clearly pose a challenge for individuals and businesses via loss of capital, but it also comes with substantial benefits. For example, riskier investments such as stocks or private equity come with a higher potential for losing money compared to a certificate of deposit. From another angle, a business that takes out a loan (a form of financial risk) has the ability to purchase more equipment or hire additional staff to increase their production—thus increasing its overall profit.
In many ways, the old adage rings true: “No risk, no reward.” That said, not all financial risk is created equal. Let’s take a look at the types of financial risks you can face.
Common Types of Financial Risk
There are multiple types of financial risks both businesses and consumers should be aware of. Here’s a brief explanation of some of the most common types.
Market Risk
Market risk for individual investors refers to the potential for price decreases in investments. This can be due to external factors, such as interest rates being increased by the Federal government. It could also be due to internal factors, like a company that has a bad earnings report.
An easy example for an investor would be the stock market dropping after Donald Trump announced tariffs on imports from the U.S.’s trading partners.
From a business standpoint, market risk refers to how the environment your business operates in is subject to changes that could threaten your profits. A prime example of this is ecommerce businesses like Amazon reducing brick-and-mortar shopping stores’ clientele.
Credit Risk
Credit risk refers to the potential for a business partner or loanee to not meet their financial obligation to repay money. For individuals, an example of this would be loaning money to a friend that is never repaid.
For businesses, especially banks, credit risk is the chance that a borrower does not pay back their loan. This is also known as defaulting.
Liquidity Risk
Liquidity refers to how quickly—or easily—an investment can be sold (i.e. converted into cash) without affecting its price. Liquidity risk, broadly speaking, is the potential for a business or individual to not be able to sell an investment or asset and have their cash flow interrupted.
From a business standpoint, an example of liquidity risk would be a company holding assets that are difficult to be sold, such as obsolete equipment or technology. If this company needed cash quickly to pay off debts, they could be at risk of not being able to access cash due to a failure to liquidate or sell its assets.
Individuals face liquidity risk when they purchase investments that do not have a high transaction volume or are difficult to sell. A simple example is purchasing a certificate of deposit. While you get a guaranteed return, you lock your money in (unless you pay a penalty or forfeit earned interest). This means that you increase your liquidity risk should you need that money in the short-term.
Operational Risk
Operational risk is only present with businesses. It refers to the potential for a business venture to fail or have its operations hampered. This could be due to a number of factors such as fraud, mismanagement, poor business design or the success of competing businesses in the area.
Inflation Risk
The increase of prices for goods and services affects both businesses and consumers alike, and its risk can be felt in many different ways.
For consumers, inflation can erode your purchasing power with cash. It can also reduce investment returns. There’s a risk that comes with having cash and investments simply due to the fact that prices can increase.
For businesses, rising costs can affect their ability to purchase essential goods or services necessary to keep their business functioning. This can bottleneck a business’ ability to generate cash and potentially increase operational risk as well.
Financial Risk Assessment: How to Evaluate Your Risks
Often it’s easy to identify certain financial risks. If you hold a large amount of credit card debt, that’s a clear risk. Or, if your business only has two clients, that’s an obvious risk to your profits. But evaluating financial risk to prioritize which ones to mitigate it is a bit more difficult.
Scenario Analysis
One method is to ask a series of questions to determine the impact of a financial risk. If the impact of a risk is great and it is difficult to deal with once it occurs, it should probably be labelled as a priority. This risk assessment tool is known as scenario analysis. Here are some questions you can use to brainstorm.
- What are the chances of this financial risk occurring?
- If it occurs, how much of an impact would it have on the business (or my personal finances)?
- If this risk impacts the business or my personal finances, what steps can we/I take to recover from it?
- What can the I or the business do to prevent this risk or prepare in advance of the risk occurring?
Value-at-Risk (VaR) Assessment
Another common risk assessment tool used to evaluate financial risks is the value-at-risk (VaR) metric. This tool measures the potential loss in an investment position over a period of time.
For example, let’s say you were thinking of buying stocks in a public company. One way of determining the VaR of that stock is to look at its historical returns and losses over a specific time period that matches your investment timeline. You would then measure how often that stock performed poorly in that timeline and if you are comfortable with that potential “worst case scenario.” Keep in mind that is a simplification of one way to calculate VaR.
Variance Analysis
Variance analysis is another method that is commonly used by businesses to see areas that are higher risk based on gaps and past performance. It might include revenue, materials, production, labor and overhead. This type of can help protect against a future lack of cash flow.
Regression Analysis
The regression analysis model can help determine the relationship between variables and help predict future financial relationships. This is a more advanced method that involves more complex statistical data sets. It might be used for financial forecasting or assessing the volatility of stocks.
Financial Risk Assessment Software Tools
For businesses or more advanced financial risk analysis needs, there are also a number of software programs that can help measure financial risk. These are especially pertinent to finance industries and investors. These tools can often provide analysis, reporting, monitoring and even audits
Regardless of what type of risk assessment tool or financial risk analysis methods you use, understanding the type and number of risks you face before making a financial decision is critical.
Financial Risk Management: Key Strategies for Individuals and Businesses
Seeing all the different types of financial risks can feel overwhelming. How can you avoid all of those different financial pitfalls? The key is to find strategies that mitigate or reduce your risk exposure.
Mitigating Financial Risk for Individuals
Some key risk management strategies for individuals include:
- Proper budgeting: Keeping track of your expenses and ensuring you have enough cash flow to cover them is a simple way to reduce your liquidity risk. It can also help you repay your debts so you can focus on using your money for more lucrative opportunities, such as investing in stocks or bonds.
- Managing debt: Learning how to manage and repay your debts can give you more access to cash in the long run: instead of paying into an overdue credit card, you can have access to that money in your account. In some cases, such as when you start a debt management plan, you can reduce your debts and lower your corresponding credit risk in the eyes of banks and other lenders.
- Increase savings: Building up your emergency savings to around three- to six-months worth of expenses can significantly decrease your financial risk. If you face unexpected expenses, rather than taking out an emergency loan you can pull the money from your nest-egg.
- Adding insurance: Whether it’s health, life, disability or property insurance, having a plan in place to protect you and your loved ones is always a prudent risk-reduction technique. This can ensure your assets are protected in the event of a tragedy and that your family can continue to financially operate.
Reducing Financial Risk for Businesses
Business risk management strategies are similar to those for individuals, but they can be more complex. Some common strategies include:
- Diversify investments/income: Creating additional streams of income or investment types in a corporate portfolio can reduce financial risk that comes with offering only one type of good or service. Diversification also applies to clients. Where possible, do not rely on a small number of clients to generate profits, as market changes or negative economic developments can quickly disrupt your profits if one or two clients leave.
- Create a risk management plan: Writing up a risk management plan is a clear step to aim to reduce risks—it helps your organization become more aware of them. A financial risk management plan would include how your company assesses, identifies and reduces financial risks.
- Create a contingency plan: Sometimes financial risk cannot be avoided and consequences follow. Creating a contingency plan for if a financial risk occurs can help you navigate a risk and reduce its effect. This could be having a list of potential vendors to contact in case a supplier falls through, for example.
- Purchase insurance: Insurance is a cornerstone of proper financial risk mitigation. While professional and general liability insurance are typically enough for some businesses, it’s important you review your company’s individual risks to see if additional coverage would be beneficial.
Why Identifying Financial Risk Is Essential
Identifying risks is a normal part of living wisely, and the same principle should be applied to financial decisions. Whether you’re an individual investor or a business owner with hundreds of employees and thousands of decisions to make, understanding and controlling financial risk will lead to better financial outcomes time and time again.
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