What is financial risk?
Risk can be quoted as the chances of having an abrupt or pessimistic outcome. Any activity or action which leads to any kind of loss is a risk. Financial Risk is among the major considerations of every business across the globe. It can emerge in many forms – from customers, suppliers, and even the company’s business strategy if risky decisions are made.
What are the main components of financial risk?
Risk is a frequent factor in business. Financial risk usually applies to finance small business activities. This involves the probability that business owners may lose large amounts of investment while debt financing. Some of the major components of financial risk are:
- Interest Rate:
The interest rate is the most important component of financial risk. In economics, the interest rate is most often considered the cost of money. It represents payments made by the business owner to the bank or lender to receive a loan. High-interest rates increase the cost of a business significantly. Adjustable interest rates increase the financial risk as the rate fluctuates according to the nation’s monetary policy.
- Amount of Credit
The amount of credit shows the size of loans offered to a company. Banks or lenders generally review the financial history of a company to figure out how much money to loan the owner of the business. Business owners must review the banking environment carefully to ensure if enough credit is available before expanding operations.
· Cash Flow
Cash flow is an important component of financial risk. Often business owners use external financing for starting a new business venture. It represents the fixed cash outflows that are to be paid regardless of the profitability of the company. Businesses with inactive sales and high cash flows may endanger the personal financial assets of their owners.
· Market Risk
Financial risks are also linked to market risk. It is the possibility of loss that a business owner faces due to the full banking industry. Banks with progressively declining the returns can build up the market risk which relates to business financing.
TYPES OF FINANCIAL RISK:
Risk is identified as the chances of having an unpredictable or unfavorable outcome. There are various types of risks that a business might face or need to overcome.
Generally, risks are classified into three types i.e., Financial Risk, Mon-business Risk, and Business Risk.
Financial risk is the high-preference type of risk for every business. It can be classified into:
· Market Risk:
Market risk arises as a result of movement in the prices of financial gear. It is classified as Directional or Non-Directional. Directional risk begins due to the fluctuations in interest rate, stock price, and more; while Non-Directional risk, is the volatility risks.
· Credit Risk:
This type of risk appears if a business owner fails to fulfill his commitment towards the counterparties. Credit risk is classified into the Settlement Risk and Sovereign Risk. Settlement Risk appears when one or both parties fail to fulfill the obligations, while the other one fails to make payment. The sovereign risk appears as a result of tough foreign exchange policies.
- Liquidity Risk:
Liquidity risk appears when a business owner is unable to execute transactions. It is classified as Asset Liquidity and Funding Liquidity Risk. The Asset Liquidity risk derives either from insufficient buyers or sellers against buy and sell orders respectively.
· Operational Risk:
Operational risk happens due to operational failures including mismanagement or technical failures. It can be classified into Model Risk and Fraud Risk. The Fraud risk occurs as a result of a lack of controls, while Model risk due to the incorrect model application.
· Legal Risk:
This Legal risk arises due to legal constraints including lawsuits. Whenever a company faces financial losses due to legal proceedings, it is a legal risk.
MEASURING FINANCIAL RISK:
Risk is linked with the dispersion in the expected outcomes. Dispersion refers to the variability. If there is no variability in the return of an asset, it has no risk.
There are various ways to measure the variability of returns. The difference between the lowest and highest possible rate of return is i.e., the range of return is one measure, but it is based solely on two extreme values.
The sum of each possible rate of the return’s squared deviation from the likely rate of return multiplied by the possibility that the rate of return exists i.e., the variance of an asset.
Standard deviation is the third and the most popular technique to measure the variability of returns. It is denoted by σ, simply the square root of the variance of rates of return.
HOW TO MANAGE FINANCIAL RISK IN YOUR BUSINESS:
The most common ways by which the financial risk can be managed, are discussed as follows:
- Carry the proper amount of insurance
Insurance is assumed to protect you from losses that you cannot afford to replace. It does not mean to cover smaller expenses. Keep this point in mind while paying higher premiums for lower deductibles.
- Diversify your investments
Diversification is critically a cautious and essential financial planning strategy. Although it does not eliminate the losses in a severe downturn, it reduces the risk of financial extermination. Maintaining a well-diversified and balanced investment portfolio assists to minimize the risk by diversifying the investments across multiple classes.
- Maintain adequate emergency funds
Maintaining dual emergency funds contributes as a sidestep against the unexpected. This relates to keeping a small fund to help during low-impact financial storms and larger separate savings for an emergency account for living expenses of three to six months.
- Have a second source of income
With the clear importance of investments, diversity also pays to your income. It is the best way to survive an unexpected situation. It allows you to start up a side business of your hobby, thereby making you able to find additional money earning way without even leaving the home.
- Maintain your health
The cheapest health insurance is staying physically fit. The risk of physical ailments and diseases can be minimized significantly by a simple exercise and maintenance of a healthy diet.
- Keep an exit strategy for every investment you make
No one can guarantee that an investment will be acquired at the best price, but controlling how much to lose ultimately is a smarter vision. The best way to achieve that is by overcoming the emotions. So, keep an exit strategy whenever taking a position on a bond, stock, or any other investment.
- Always read the fine print
Whenever reviewing a contract, double-check you read the fine print. It usually consists of language which gives an advantage to another party while having a dispute and that may result in costing you big money.
- Keep your debt to a minimum
Taking on enormous debt significantly reduces the revenue you can accumulate consequently. By keeping the debt to a minimum, the chains that avert from attaining financial freedom can be avoided, meanwhile keeping control over the life of the business owner.
- Stay employable
Everyone can be replaced except for the one who found a way to prepare himself as a key employee to his employer. Do not rest on your awards. Challenge yourself constantly and never stop learning. Always volunteer to do the difficult jobs that no one else wants.