5 Types of Financial Risk You Need to Know

4 Types of Financial Risk You Need to Know
No company is launched without the owners and investors alike acknowledging and analyzing the risk. Risk is a part of any business, regardless of the sector. And at 5th Line Capital, we can help you manage it.

Successfully managing that risk can mean the difference between a growing, thriving company and just another sad statistic. While some risks are within the control of company management, other risks are almost entirely beyond any control.

Managing Types of Financial Risk

For example, the risk that an employee would steal assets from the company is, for the most part, a manageable risk. Security safeguards, employment practices, insurance, audits and inventory control are all ways to manage this kind of risk.

Even something as seemingly unmanageable as fire or natural disaster still has an element of manageability when it comes to risk, because the threat of these disasters can be anticipated.

While there are a vast number of risks that can affect a business, nearly all will have some type of financial impact. Evaluating financial risk is typically thought of in terms of perceived financial risks that can affect cash flow. Financial risks—everything from clients not paying you to a fire—can impact your cash flow and create potential challenges for meeting your company’s financial obligations.

A good first step in managing company risk of all kinds is to think of financial risk in terms of four broad categories: market risk, credit risk, liquidity risk and operational risk. Let’s take a closer look at each of these categories for a better understanding of how risks can be managed.

1. Market Risk

The term market risk is often used in terms of investment performance. But in terms of categorizing the financial risks that companies face, the term is used to refer to those risks that involve changing conditions impacting the marketplace where the company operates.

An example of market risk that affected many mom-and-pop Main Street shops was the introduction and growth of big box retailers. A more recent example—accelerated by the pandemic—that impacted many retailers was the phenomenal increase in online shopping. While this impacted a large number of retailers, it hit smaller, locally owned shops hardest because they were less likely to be in a position to manage the risk with a robust online shopping and shipping option.

In both examples above, those retailers that were able to pivot—whether via more competitive pricing and greater selection or availability of online shopping options--saw their revenues grow. Those that were either unable or unwilling to adapt to changing demands saw their revenue wither.

As we see by these examples, market risk is not limited to changes in consumer behavior. Market risk also includes the threats to cash flow due to action by a competitor or group of competitors. An example would be the growing competition from big box stores.

2. Credit Risk

This category of financial risk is defined as the risk that companies take on when they extend credit to customers. In addition, the term is often used to include the credit standing a company maintains with its suppliers and vendors.

The risk a company takes on by extending credit is obvious. A customer may default on their payment, impacting cash flow. The company, in turn, must also manage its own credit obligations and ensure sufficient cash flow to meet them. If not, suppliers and vendors may decide not to extend credit in the future, which could impact cash flow.

3. Liquidity Risk

You may have heard the term liquidity risk used in conjunction with financial institutions. Funding liquidity risk played a major role in all banking crises throughout history prior to the Basel Accords.

Liquidity risk as used with non-financial businesses refers to the ease by which a business is able to liquidate assets to meet daily cash flow needs, should a sudden and significant need occur. An example of this would be a business that experiences normal seasonal downturns. The business must still be able to meet its daily operating expenses so that it can survive the downturn.

Liquidity risk encompasses operating funding liquidity, which is sometimes referred to as cash flow risk. This is a term used to describe the risk that a company will be unable to meet its short-term obligations in a timely manner.

4. Operational Risk

The operational type of financial risk is a broad category that occurs due to a company’s day-to-day business activities. Examples of scenarios that would be considered operational risks would be personnel problems, lawsuits and fraud. For example, a customer of a massage therapy business who claims she was assaulted during her massage files a lawsuit against the company for not thoroughly backgrounding the accused employee and not having safeguards in place. Managing this would be considered a part of managing operational risk.

5. Model Risk

An additional type of operational risk is referred to as model risk. Model risk is the risk that the company’s models of marketing or growth projections prove to be inaccurate or, at the least, inadequate. For example, modeling may have projected stronger demand for product X if it is changed to include ingredient Z. However, despite being based on volumes of consumer research, the new product X turns out to be a dismal failure. This illustrates there is a certain measure of risk when relying on models to project future sales and growth. These are considered a part of operational risk.

Managing risk is a part of operating a business and most companies deal with multiple types of financial risks. Understanding these financial risks helps you to manage them and will assure your company is in the best possible position to attract outside capital.

Contact us at 5th Line Capital for services and finance strategy options for your business. We are here to help you manage your business in a way that supports your finance team and operations.