What is financial risk? How to identify and control it
What is financial risk?
Financial risk describes the chance of losing money on an investment or from your business. Market volatility, economic downturns, unpaid invoices, fluctuating interest or currency exchange rates can cause financial risk.
Why is it important to identify financial risk?
It's important to identify financial risk to minimise losses while working towards your goals. Risk management strategies include diversification, robust business processes and insurance.
What are some examples of financial risk?
Examples of financial risk facing small business owners include:
Credit risk
Credit risk is a term commonly used in lending and finance but also applies to businesses. The possibility that your clients pay your invoices late or not at all is a credit risk.
Economic risk
Economic risk is the possibility of losing money through changes in the wider economy caused by inflation, recession, political instability and more.
Profitability risk
Profitability risk is the possibility that your profits or earnings will go down because of increased competition, changes in consumer preferences, the rising costs of production or materials and more.
The impact of financial risk on individuals
Your company's financial risks can impact you as a business owner. To pay down business liabilities, you may need to use assets you hold privately, such as your family home or savings. Liabilities include debt to suppliers or staff, everyday business expenses or settling lawsuits.
How to control financial risk
Controlling your financial risk means avoiding adverse outcomes and minimising the impact on your business. The various steps can be grouped under risk reduction, transfer, retention and avoidance.
Risk reduction
Risk reduction helps you minimise financial risk or its negative impact. Some examples of risk reduction include:
Diversifying your customer base, products or services
Regularly maintaining equipment or property
Reducing fixed operating expenses like debt repayments, rent or salaries
Training employees on safety protocols, cybersecurity and other risk management strategies
Strengthening your contracts with suppliers, partners and customers
Keeping cash reserves for unexpected expenses
Conducting background checks on employees and suppliers
Risk transfer
Risk transfer is when you shift the possibility of financial loss to another company. The most common form of risk transfer is insurance.
Risk retention
Handling your risk internally rather than transferring it to a third party, like an insurance company, is risk retention. Some risk retention strategies include:
Setting aside contingency funds to cover potential losses instead of buying an insurance policy.
Agreeing to pay a higher excess on an insurance claim to secure a lower-cost premium
Risk avoidance
Focus on eliminating risk using risk avoidance. Some examples include:
Developing and enforcing policies that protect your business against fines and lawsuits
Refusing clients who may not be profitable
Avoiding fixed costs like rent or employees
Paying for expenses with cash rather than using business financing
Financial risk: systematic vs unsystematic risks
Systematic risk is also known as economic risk. The whole economy faces this risk caused by factors like government policies, inflation or natural disasters. Unsystematic risk, also known as specific risk, affects just your company or industry, like changes in management, lawsuits, labour disputes and supply chain disruption.
Financial risk FAQs
What is the difference between financial risk and market risk?
Financial risk is a catchall term to describe any risk to your business that could impact your finances. Market risk is a financial risk caused by movements in the financial markets that affect the value of stocks, bonds and derivatives.
What is financial risk vs economic risk?
Financial risk describes any risk that could impact your finances. Economic risks are financial risks that affect the overall economy, such as recessions, unemployment and political instability.
What are the three main sources of financial risk?
The three main sources of financial risk for SMEs are
Credit risk caused by mismanaged debtors
Economic risk impacting supply, demand and profitability
Operational risk, including operational inefficiencies, human error and fraud
What are the most common financial risks?
The most common financial risks facing small business owners are
Economic risk, associated with the changes in the wider economy
Market risk, caused by fluctuations in the market
Credit risk, when your customers or clients or debtors don’t pay you
Operational risk, arising from internal processes, systems and human error, like fraud or cyber-attack.
Be prepared to be successful
Each business will face financial risks broadly falling into market, economic, operational, profitability and credit categories. Understanding what to look for in your business can help you take steps to avoid, reduce, transfer or retain the risk to minimise the potential for negative impact.
To assess these financial risks and how best to manage them, you'll need an accurate picture of your numbers — and that's exactly what you get with MYOB's cloud accounting software. The built-in analytics and forecasting options give you the insights to prepare for financial risks and plan for a successful future.
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Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.