Financial risk management can be a volatile sphere, especially in an ever-changing social and economic landscape. The key to managing financial risk effectively is understanding it better. Find out what the current 2024 financial risk landscape looks like. In this blogpost, we will explore:
- What financial risk means
- The 7 key types of financial risk
- 5 strategies that can help you manage financial risk effectively
What is financial risk?
In the world of business and personal finance, financial risk is an inevitability. It refers to the risk of suffering financial loss as a result of unanticipated circumstances or adverse market conditions. Understanding financial risk is essential for protecting your assets and helping you make wise decisions with regards to fraud, lending, acquisition, and others.
Financial risk can include many possible dangers, ranging from credit defaults and market swings, to operational risks and regulatory changes. You can strengthen your financial risk management by identifying the different kinds of financial risk and putting effective risk mitigation techniques into place.
What are the 7 key types of financial risk?
Businesses and SMEs are subject to a variety of financial risks that can have a substantial influence on their operations and profitability. A recent report showed that in 2024, there has been a 25% surge in the number of businesses facing critical financial risk. In the final quarter of 2023, roughly 50,000 UK companies were facing some kind of financial distress.
Identifying these hazards is vital for efficient risk mitigation and guaranteeing long-term financial health. Below are some of the main categories of financial risk that all businesses may encounter:
1. Market risk
Market risk is the result of general market fluctuations, such as shifts in interest rates or stock market crashes. For instance, if a business depends significantly on exports, a sharp decline in the value of the home currency may reduce the competitiveness of its goods abroad. A comprehensive financial risk assessment can help you identify what the key market risks are so that you’re in a better position to mitigate them.
2. Credit risk
Credit risk arises when there is the possibility that suppliers or customers of a business would miss payments on their contracts. For example, financial difficulties and cash flow issues may result from a significant customer's failure to pay their invoices. It is important to have a robust credit risk solution to mitigate this type of risk.
3. Liquidity risk
Liquidity risk is the possibility that there won't be enough cash on hand or liquid assets to cover short-term financial obligations. This risk is particularly prevalent in SMEs that may have little access to credit.
4. Operational risk
Operational risk is caused by either external or internal events that interfere with a company's ability to conduct business. Fraud, natural disasters, and system failures are a few examples. Being aware of early fraud indicators may help you significantly curb this risk.
5. Foreign exchange risk
When businesses transact in foreign currencies, there is a foreign exchange risk. They can lose money on their foreign currency contracts if the exchange rate swings against them.
6. Commodity price risk
This can arise when the costs at which a business purchases or sells commodities fluctuate. For example, growing oil costs may have a negative impact on a manufacturing business that uses oil as a major input.
7. Regulatory risk
Regulatory risk is the possibility that modifications to laws or regulations will have an adverse effect on the business operations or financial results of an organisation. For instance, new Environmental, Social, and Governance (ESG) regulations may cause manufacturers to conduct more rigorous audits of their suppliers to ensure they are complying with ESG standards. This may increase cost and potentially disrupt supply chains.
Enterprises and SMEs can strengthen their resilience and safeguard their financial performance by identifying these financial risks early and putting appropriate risk management plans into place.
5 strategies to manage financial risk
For any business, financial risk will always exist. A proactive financial risk management strategy is necessary to safeguard your company's financial health from market changes and unforeseen setbacks. The following are some essential tactics to reduce financial risk and guarantee stability over the long run:
1. Adopt a diversified approach
Avoid placing all of your eggs in one basket. Make sure to diversify your portfolio and money streams to ensure that one incident of financial risk does not significantly jeopardise your company. This lessens the effect of a decline in any one sector.
2. Hedge against fluctuations
Take into account hedging techniques to guard against unfavourable changes in the market. This can entail offsetting possible losses with the use of financial instruments like options contracts.
3. Make strong financial risk management a priority
Before granting credit, determine a potential client’s financial risk. Also, protect yourself against fraud by identifying inconsistencies in their financial activities. To evaluate client risk profiles and reduce the likelihood of bad debts, make use of business information platforms such as Company Watch.
Company Watch can help you protect your portfolio and guard against financial risk by identifying and analysing critical data points taken from Companies House and other data sources.
4. Keep liquidity buffers
A solid cash reserve can help you withstand unforeseen financial storms. This enables you to fulfil short-term commitments even during times of low income.
5. Create a culture of risk awareness
Establish a culture of risk awareness by giving staff the tools they need to recognise and report possible financial hazards. Encourage proactive risk reduction initiatives and cultivate an environment of open communication.
Through the application of these tactics, businesses can drastically lower the amount of financial risk they are exposed to. Remember that long-term success and protecting your company's financial stability require a proactive attitude.
With Company Watch’s host of robust business information tools, you can safeguard your company against all kinds of risk in a thorough, streamlined, and efficient manner. If you’re not sure where to start with your financial risk management, try our platform for free to discover where your immediate risk needs sit and how we can address them.
