Financial risk refers to your business' ability to manage your debt and fulfil your financial obligations. This type of risk typically arises due to instabilities, losses in the financial market or movements in stock prices, currencies, interest rates, etc.
Difference between business risk and financial risk
Business risk relates to the basic viability of a business. It refers to your ability to turn a profit and cover your operating expenses, such as salaries, rent, production costs and office expenses.
Financial risk, on the other hand, is concerned with the costs of financing and the amount of debt you incur to finance your operations.
Types of financial risk
Common categories of financial risk include:
- market risk
- credit risk
- liquidity risk
- operational risk
Market risk relates to the probability of incurring a loss due to things like market volatility, hikes in interest rates or raw material costs, fluctuation in foreign currency values, etc. For example, exchange rate changes will affect your debt repayments and the competitiveness of your goods and services compared with those produced abroad.
Credit risk is the probability of failing to pay to a creditor (such as a bank or a lender) or another party (eg a supplier). You may also incur credit risk by extending credit to customers, due to the possibility of them defaulting on payment.
Liquidity risk affects your ability to meet short-term financial demands to execute your business transactions. Key sources of risk are potential cashflow problems, because of things like the seasonal downturn in revenue, lack of buyers for your assets or inefficient market.
Operational risk is the likelihood of incurring a loss due to the negative effects of procedures, systems or policies you have in your business. Common sources include technical failures, fraud activity, employee errors, etc. Find out more about operational risk.
Financial risk management
Managing financial risks is a high priority for businesses, irrespective of their size or industry. In order to take control of the financial risks, you need to:
- identify and measure the risks
- decide on the level of risk you are willing to accept
- consider insurance to protect against business risk
- identify potential issues with cashflow
- review your financial arrangements with creditors
- be careful if extending credit to customers
- diversify your income sources
- regularly reassess your risks
Make sure to consider the various factors affecting financial risk. Broadly, these fall under two categories:
- external factors - including economic downturns, market rates, industry changes, law changes, etc
- internal factors - including underperformance, poor cashflow management, bad investments, new competition, staff issues, etc
Take into account both external and internal factors when carrying out a financial risk assessment. Find out how to evaluate business risks.
Read about other strategies to manage business risk.