What’s life without a few risks? A certain amount of risk is vital to improving, growing, and living a fulfilling way. The same holds true for your business.

When you start your own business, taking a risk or two is inevitable. Small businesses are passion projects that demand time, effort, and a bit of chance. It’s inherently a part of the business. 

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Since you can’t predict the outcome of a financial risk or sometimes even avoid it, business owners need to stay one step ahead by anticipating potential risks and planning for them. However, the financial market is volatile, and controlling every single aspect of it is nothing short of impossible. Hence, a good risk management plan is essential to counter financial risks in business, nip the problem in the bud, or bring an end to a seemingly never-ending crisis. 

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In today’s growing economy, the role of a Financial Risk Manager continues to gain importance. FRM (Financial Risk Manager) is one of the most prominent accreditations available to risk management professionals all over the world. 

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But before you begin with the planning process, what you need to know are the kinds of financial risks in business.

Types of Risks in Business:

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1. Business Risks: Taken by the entrepreneur or business owners to maximize shareholder values and profits.

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2. Non-business risks: These are risks that are caused due to political and economical imbalances on a global scale.

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3. Financial Risk: These risks can cause financial loss to the business/business owners. Financial risk can be due to various factors and broadly fall under two categories. They can be external, due to changes in the financial market like instability or losses due to stock prices, interest rates, exchange rates, currency, and so on. Economic downturns, market-rate fluctuations, industry or law changes are also external factors. 

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Internal factors are more on lines of bad investments, poor cash flow and management, underperforming employees, staff issues, and so on.

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Non-business risks and certain financial risks are usually not in the control of a business owner. These kinds of risks come with starting a business and tend to affect the entire financial market or global market equally. 

Although they are out of one's control, some businesses recover faster as they are adept at managing or effectively countering these risks with the right planning.

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So what are the kinds of financial risks in business?

Credit Risk:

Credit risk can be caused due to an array of reasons, but it mainly means the probability of failing to pay a creditor. These can be classified into two types, depending on the parties involved in the exchange of credit.

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• Sovereign Risk: Often caused by difficult foreign exchange policies, and regulations  
• Settlement Risks: This is the more common kind of credit risk when one party is unable to fulfill the obligations towards the counterparts invested in your business. 

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Whether it is private investors or banks, when the business is unable to fulfill its obligation or show a return of investment to these parties, it leads to credit risk. Credit risk can also occur due to extending credit to customers who default on payment.

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Thus, it is essential that companies ensure they have enough of a cash flow to pay all their bills on time, and plan for any further miscellaneous expenses which supplier credit can be used for (suppliers like investors, banks, manufacturers, etc.)

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Leverage Risk:

An element under credit risk, but just as important to consider, is leverage risk. Leverage risk assesses how indebted (borrowed) your company is. A business with more leverage will have lower equity, higher interest payments, and ongoing debt service obligations.

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Leverage risk is more common during downturns in the business cycle when there is a large drop in sales. The cash flow and liquidity of the business will be impacted by lower sales, and your interest and loan payments will account for a higher share of your total revenue.

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You can help reduce your leverage risk by understanding the drivers of your business cycle, such as supply and demand, maintaining manageable debt levels, and regularly reviewing your payback ratios and capital investment to ensure that your investments are generating commensurate returns.

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Market Risk:

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The financial market is unpredictable, dynamic, and extremely volatile. There’s always a probability of incurring loss due to fluctuations in the market, and it can affect the standing of your business. From the value of your goods and services to the debt repayments, the nature of the financial market comes with a huge level of Market Risk.

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Market risks can be directional (stock prices, interest rates) or non-directional (volatile changes in the market like large-scale bankruptcy or global recession). Market Risks are also systemic and innate to all businesses. This means, it never impacts only a specific industry, firm, or business, but the whole financial structuring and institute.

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Another element of market risk is equity risk, which is the level of risk associated with enterprises trading on the stock market. A turbulent market can make it hard for a corporation to assess the long-term value of its equity. A sinking market, in particular, might signal doom for a company that hasn't done the proper financial planning.

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You can control market risk by managing and tweaking your portfolio to mitigate the interest rates or develop policies, methods, and organizational structures that relate to commodity/energy pricing policy.

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Competition Risk:

Due to the nature of the free market, competition is an obvious risk. 

For a business to be successful, not only does it need to offer a unique value proposition (this is the value a company promises to their customer when they buy a product), but it also needs to find a strategy that makes them stand out from its sea of competitors.

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Competition Risk can manifest itself in two ways:

• New competitors: This could be a start-up or an established company growing into your market. This might lead to a drop in business or a loss of clients. To be competitive, you may need to lower your pricing, which will decrease your profit margin.
• Existing rivals:  These are competitors you're already aware of that are now able to tailor their product offering to directly target your sales, revenue, and consumers. They may opt to lower their rates on a product similar to yours or introduce a new product offer before you do. Learn how to respond to competitive hazards by adapting and growing your business.

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Operational Risk:

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Risks that arise due to operational failures, like mismanagement or technical failures, are the terms of operational risks. Every business could, at some point, have an operational risk. These can be troubles found in the day-to-day management of a business, ineffective management styles, HR issues, equipment breakdown, or even potential risks in daily operations.

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Operational Risks are of two types:

• Model risks are based on a company’s model of marketing and growth plans. As your business grows, you have to pay for inventory, increased headcount, and advertising before you notice an increase in your sales. This can impact your cash flow and ability to meet financial obligations, such as paying salaries and repaying loans. If your plans are inadequate and don’t keep up with the demands of the business or the market, financial calamity could ensue. Growing your business comes with new risks because the revenue from the sale of your product or service is received after you've paid for the assets or resources needed to grow your business. 

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• Fraud risks are to do with fraudulent or incompetent behavior in the organization. Either on a personal/individual level or employee and workplace level, any fraudulent activity committed on behalf of or within the organization is an operational risk. Bribes, misuse of assets, purposeful misattribution of funds, tax evasion, etc. all fall under operational risks.

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Businesses need to plan and cover all eventualities. It is essential to have a backup plan in case an operational risk occurs, as day-to-day functions taking a hit can affect every level of the business. 

Liquidity Risk:

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Liquidity risks include any risk related to asset liquidity and operational funding liquidity. An inability to execute transactions based on this leads to liquidity risk. This is a larger concern for seasonal businesses, which tend to have on-and-off periods and the demand fluctuates.

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When businesses are unable to pay their employees, source more stock, or meet the demands of sellers and buyers, they are at a liquidity risk. In extreme cases, a particularly bad off period could put a viable business at risk for closure.

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Liquidity Risks can be divided into two types,

• Asset Liquidity is the ability for a business to convert its assets into cash with relative ease, should the need arise. This kind of risk usually arises when there are insufficient buyers or insufficient sales against their respective buy and sell orders. In that case, the need for a quick turnover for additional cash flow is essential to keep the business afloat.
• Operational funding liquidity is the daily cash flow of a business and the issues that arise from the difficulty in maintaining the stream.

Legal Risk:

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A company's legal risk is defined as any financial losses incurred as a result of legal proceedings, as well as consequences that arise with failure to comply with the law. Legal issues also require the assistance of qualified lawyers and the charges associated with their services.

The responsibility of a business owner to protect employees from danger is often what leads to the possibility of legal proceedings. Failure to account for these risks could land your company in legal trouble.

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While the need for a legal team itself is not legal or financial risk, any unforeseen legal issue that needs an immediate resolution and can cause a financial burden is classified as legal risk. The best way to prepare for legal risk, is by having an in-house legal team that is well versed in business law, specifically in your field of business. If having an in-house team is outside the budget, it’s best to connect with a company lawyer or a firm that specializes in their field. 

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What we do know from looking at the four main types of financial risk is that these are typically unpredictable. Most businesses need to be prepared to face them as and when they arise.

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A few tips to consider when planning for risk management:

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Managing financial risk is a top priority for all businesses, regardless of size or industry.

• Identify and assess all potential risks, the nature, the likeliness of occurrence, frequency, and contingency/counter/backup plans.  
• Business owners should think about getting insurance to protect the business. It is key that an entrepreneur or business owners decide on the degree of danger they are willing to take. Picking the most appropriate insurance plan for their business is part of planning for future risks. The right insurance plan will also ensure that certain risks that you haven’t explicitly planned for, like a pandemic, are also dealt with professionally and beneficially.
• All business owners must identify possible cash flow problems, and check their financial arrangements with creditors, using caution when giving credit to customers.
• Diversifying the income sources and analyzing all risks regularly is wise financial planning and an important aspect of assessing potential risk.

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As financial risks in business are part and parcel, having a financial risk management plan in place allows you to prepare for risks that may affect your business. You can't eliminate risk, but planning for potential scenarios can help you understand which risks can be minimized, and which risks are to be avoided.

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Your financial risk management strategy should draw out a clear plan of action. This should include the current policies and procedures you use to manage financial risk, as well as a plan to deal with potential future risks, allowing you to minimize any negative impacts.  

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Remember: 

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Risks can often lead to good outcomes and new opportunities too (higher risks can lead to higher rewards), so there may be risks you're willing to take. The benefit of anticipating possible risks and their outcomes is that you are aware of the level of risk you're comfortable working with. This is called your risk appetite. But be prepared and have as many contingency plans as you can spare in the event of an undesirable outcome of the risk you are undertaking.

It's always best to connect with reliable solution providers like Hoist which has a team of experts to help you with all the nuances of business management and growth. And if you’re looking to get started with your own business, Hoist can help you set up and run a hassle-free painting business at the fraction of the cost of a franchise.  

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