Financial Risk: The Major Kinds That Companies Face

Financial risk is inherent in any business enterprise, and good risk management is an essential aspect of running a successful business.

There are different ways to categorize a company’s financial risks. For example, managers can separate financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.

A company’s management can control risk with varying levels of success. Some risks can be directly managed; other risks are largely beyond the control of management.

Sometimes, the best a company can do is to try to anticipate possible risks, assess the potential impact on the company’s business, and be prepared with a plan to react to adverse events.

Key Takeaways

• There are four broad categories of financial risk that companies can address with proper risk management measures.
• Market risk is the risk that there could be a substantial change in the particular marketplace in which a company competes.
• Credit risk arises when companies extend their customers a line of credit, or, when a company can’t pay for services provided on credit by a vendor.
• Liquidity risk refers to how easily a company can convert its assets into cash if it needs funds; it also refers to its daily cash flow.
• Operational risks emerge as a result of a company’s regular business activities and include fraud, lawsuits, and personnel issues.

1. Market Risk

For businesses, market risk can relate to changing conditions in the specific marketplace in which it competes.

Changing Consumer Preferences

One example of market risk is the increase in consumers who prefer shopping online. This aspect of market risk has presented significant challenges to traditional retail businesses.

Many companies that have adapted to serving an online shopping public have thrived and seen substantial revenue growth, while other companies that couldn’t adapt, have been slow to adapt, or have made bad decisions relating to the changing marketplace have fallen by the wayside.

Another trend is ESG (environmental, social, and governance business practices). Some companies are now pressured by customers to move from polluting industries to cleaner ones. Or from seeking profits for profits’ sake only to seeking profits while doing good in communities.

Companies who lag behind this trend could be at risk for being poor in capital, short in talent, and unfortunate in branding.

Agility of Competitors

Another element of market risk is the risk of being outmaneuvered by competitors.

The global marketplace is increasingly competitive, often with narrowing profit margins. The most financially successful companies are those that offer a unique value proposition that makes them stand out from the crowd with a solid marketplace identity.

Note

Market risk can also relate to the risk of loss due to changing product prices, stock prices, currency rates, and interest rates.

2. Credit Risk

Businesses face credit risk when they extend credit to customers, essentially allowing them to make purchases without immediate payment.

As long as customers who buy on credit pay their bills, the company avoids loss. If they default on payments, then the company has a problem.

Credit risk can also refer to the company’s credit line with suppliers. A company must ensure that it always has sufficient cash flow to pay its accounts payable bills in a timely fashion.

Otherwise, suppliers may either stop extending credit to the company or even stop doing business with the company altogether.

Important

While managing risk is an important part of running a business effectively, a company’s management only has so much control. In some cases, the best thing management can do is to anticipate and prepare for potential risks.

3. Liquidity Risk

Liquidity risk involves asset liquidity and operational funding liquidity.

Asset liquidity refers to the ease and speed with which a company can convert its assets into cash should there be a sudden, substantial need for additional cash flow.

Operational funding liquidity refers to the amount of daily cash flow being enough to meet short-term liabilities and obligations, and keep the business running smoothly.

General or seasonal downturns in revenue can present a substantial risk if the company suddenly finds itself without enough cash on hand to pay the basic expenses—salaries, vendor bills—necessary to continue to function.

This is why cash flow management is critical to business success—and why analysts and investors look at metrics such as free cash flow when evaluating companies as an equity investment.

4. Operational Risk

Operational risks are the various risks that can arise from a company’s ordinary business activities. The operational risk category includes lawsuits, fraud, and personnel problems.

It also involves business model risk, which is the risk that a company’s models of marketing and growth plans may prove to be inaccurate or inadequate.

With All the Inherent Risks, Why Do People Start Businesses?

People start businesses when they fervently believe in their core ideas, their potential to meet unmet demand, their potential for success, profits, and wealth, and their ability to overcome risks. Many businesses believe that their products or services will contribute to the good of their community or society at large. Ultimately (and even though many businesses fail), starting a business is worth the risks for some people.

What Is Financial Risk?

Broadly speaking, financial risk is the risk that a business could lose money on an investment it makes or due to its decisions about its operations, its borrowing, or its market (including competitors).

Is Managing Risk a Big Part of Business?

Yes, it’s a crucial and essential effort that businesses make so that they may prevent financial loss. Many businesses employ individuals whose sole job is identifying and mitigating risk. Large companies in particular staff entire departments devoted to risk management.

The Bottom Line

All businesses face different forms of risk. Risk is built in when starting and running a business, and as a company makes moves to achieve lasting success.

Normally, businesses can’t avoid risk but they can manage and reduce it.

Four broad categories of financial risk for businesses are market risk, credit risk, liquidity risk, and operational risk.