What is Financial Risk and How to Control It?

Introduction

In today’s time of economic uncertainties, the concept of financial risk management has become a significant concern for organizations of all sizes.

Financial risks are all about the possibility of losing money or facing financial uncertainties. It is an inherent part of any business venture and every entrepreneur or individual must comprehend and manage it wisely. Every financial decision carries a certain level of financial risks. Amongst all the risks, financial risks stand out owing to direct impact on the capital.

Whether you are investing in a business or running an organization while borrowing funds for business expansion, you can easily get affected by financial risks. If left unaddressed, these risks can affect your financial stability, influence on your decisions, and erode wealth.

This is why it is essential to understand the meaning and nature of financial risks, their types, and strategies to control them. However, doing so will empower you in making informed and smarter financial decisions.

What is Financial Risk?

Financial risks refer to losing money/capital due to unfavourable decisions or due to external event or poor performance. In simple terms, your financial activity or investments may not yield desired outcomes, further leading to losses.  However, it is not limited to any investments or stock markets; even government and private organizations also face financial risks during uncertainties. Importantly, economic changes can not be predicted with certainty.

Our goal should not be solely on eliminating the risks, which is impossible. Instead, we should aim to manage financial risk and minimize its impact when circumstances go out of the way.

Why is it Essential to Understand Financial Risks?

Having a thorough understanding of risks in finance is essential for several reasons:

• It helps safeguard assets from unexpected losses.
• It allows for making informed business decisions
• It helps in long-term financial goals planning.
• It can increase profitability

Furthermore, identifying financial risks enables businesses and individuals to remain financially stable, even during economic uncertainties.

Types of Financial Risks

 1.  Market Risk

Market risks are due to fluctuations in prices, including stock prices, interest rates, and currency values, among others. Additionally, investors are highly prone to market risks owing to external factors, such as global events, government policies, which further significantly influence financial markets.

How to control – It is advisable to diversify your investments across various sectors to reduce market risks.

2.  Credit Risk

Credit risks occur when a borrower fails to repay the loan amount or doesn’t fulfil the contractual obligations. It is a major concern for investors, lenders, and banks.

How to control- Set credit limits, keep collateral to reduce risks, and assess the creditworthiness of the borrowers

3.  Liquidity Risk

It is a risk that arises when an organization fails to meet short-term financial obligations, as the organizations can’t quickly convert assets into cash without incurring loss.

How to control – Maintain a balance between liquid assets and illiquid assets. To be on the safer side, always have an emergency fund to cover unexpected expenses.

4.  Operational Risk

Operational risk is a loss due to failed internal business processes, human error, or external events. These risks could be witnessed in almost any business.

How to control – Conduct audits on a regular basis, implementing strong internal controls, and timely training employees to handle the work efficiently. Additionally, accurate bookkeeping and accounting helps businesses to manage financial risks at the early stage.

5.  Legal and Regulatory Risk

This category of risk arises due to organization’s non-compliance with laws and regulations, or contractual obligations. This can potentially lead to paying fines, reputational damage. It is also considered as a sub-category of operational risks.

How to control – Stay up-to-date with legal regulations, consult compliance experts, and implement transparent business practices.

How to Identify Financial Risks?

Identifying financial risks should start with carefully reviewing various factors that impact your money flow and investments. From a business perspective, it includes analyzing internal and external business economic indicators. For individuals, it involves checking debt levels and analysing the market conditions prior to making further financial decisions.

Effective ways to recognize financial risks:

• Conducting market analysis
• Consult with financial experts
• Evaluating financial statements
• Perform risk assessment

How to Control Financial Risks?

Handling and managing financial risks require recognizing potential threats and implementing essential financial risk management strategies to reduce their impact on businesses/individuals.

Here are some of the most effective financial risk control methods:

1. Diversification 

Don’t put all your savings and investments in a single place. Spread across different sectors, including mutual funds, bonds, and stocks and to avoid the impact of losses and being reliant on one single area.

2. Hedging Techniques 

Hedging tools include financial instruments, such as futures, options, and derivatives to overcome the potential losses.

3. Maintaining Sufficient Liquidity 

To handle emergency financial crises or overcome short-term financial obligations, always keep sufficient cash or liquid assets in hand. Doing so prevents selling forced assets at lower prices during an emergency financial crisis.

4. Risk Assessment 

Regularly track financial performance of the organization and analyse market trends. In addition, ensure to update financial risk management strategies as the situation demands.

5. Insurance 

Insurance is considered to be one of the best ways to transfer financial risks to third party organizations and quite essential for managing financial risks. There are several business insurance policies, which cover all sorts of financial risks, such as credit insurance, property, liability, commercial property claims, workers compensation, cybercrime, among others. The insurance policy covers premium costs and helps financial recovery, but doesn’t eliminate the risks or disruption caused.

6. Establishing Risk Limits 

Set clear boundaries regarding how much risk you are willing to take up. For individuals, setting risk limits is about determining your risk tolerance prior investing, while for businesses it is about setting credit exposure limits.

7. Staying Informed 

Fluctuations in economic trends and financial interest rates can easily impact the financial stability of the business. Therefore, staying informed helps you quickly react to reduce the probability of losses and grab new opportunities.

8. Invest in Employees 

It’s actually the employees that make a bigger impact on the success or failure of the business. In fact, there is a correlation between business output and employee training.  Investing in training employees reduces the risk of costly errors damaging the organization’s reputation.

9. Build a Strong Financial Strategy 

Creating a strong financial risk management strategy helps to manage financial risks by estimating expenditure, setting goals, and predicting business returns. On a regular basis, review your business financial strategy and adapt to market changes.

Pros of Financial Risks

When financial risks are handled wisely, it creates positive outcomes for both investors and businesses.

Pros of financial risks, include:

• Better decision making
• Improved profitability
• Financial stability
• Long-term growth
• Stimulates economy
• Higher returns

Cons of Financial Risks

When financial risks are unmanaged, it can cause potential setbacks which might take years together to recover.

Cons of financial risks, include:

• Uncertainty
• Volatility
• Losses
• Regulatory Challenges

Conclusion

Financial risk is an inevitable part of business investment and operations. While the financial risks make the organisations prone to potential losses, but it doesn’t have to be a threat, it makes way for economic growth and innovation. The key for economic growth lies in comprehending various types of risks and preparing financial risk management strategies to manage them and achieve financial success.

The more you understand and learn, the more confident and secure you financial future will be, contributing to sustainable growth rather being a hurdle.