Why Financial Risk Management Is Vital in Uncertain Times

One of the biggest concerns for any company in the entrepreneurial ecosystem are those situations that could put its financial stability in jeopardy. Identifying, assessing and responding to risks is a process that extends throughout the entire cycle of any business. Financial risk is associated with uncertainty regarding the return on an investment because of changes in a company’s industry, the failure of one of the parties to repay the capital and the volatility of the financial markets.

What are financial risks?

Financial risks are the potential losses that a company could face as a result of market volatility and economic uncertainty. These risks are associated with exposure to fluctuations in prices, interest rates, exchange rates or any other factor that affects the value and obligations of financial assets.

On the other hand, a company’s own operations and decision making can also be the source of financial risks. These are operational and management risks, ones that result from bad practices, human error, problems in internal processes, lack of planning and supervision, and lack of transparency and communication.

Financial risk management is therefore a comprehensive process that involves identifying, assessing and controlling the risks associated with the organisation’s financial operations. The primary goal is to minimise potential losses and optimise profit opportunities, a process critical to ensuring a company’s financial stability and soundness.

This process is also instrumental when it comes to securing funding, a core issue for the startup ecosystem. Investors and lenders often evaluate a startup’s risk management before investing or providing funding. Sound risk management ensures investor confidence and makes it easier to tap into capital.

Types of financial risks

Managing risks involves implementing policies, procedures and internal controls, as well as adequate staff training, constant oversight and fostering a corporate culture that incorporates these factors. Additionally, having early detection and rapid response mechanisms in place is vital if you want to tackle any risks that do come up and minimise their impact. But the first step is understanding the most common financial risks:

Market risk

Associated with risks inherent in the financial system, market risk is the risk of losses in the value and position of an asset arising from market fluctuations. There are several types of market risks:

• Currency risk. The risk associated with fluctuations in exchange rates that affect assets, liabilities or income in foreign currencies.
• Interest rate risk. Exposure to losses from movements in interest rates that affect the value of debt instruments.
• Price risk. The possibility of loss due to adverse changes in the prices of financial assets (stocks, bonds, commodities, etc.).

Credit risk

Credit risk is related to a party’s inability to repay the debt owed. It may refer to the risk of default of a borrower or a debt issuer failing to meet its interest or principal payment obligations. It also includes the risk that a counterparty will not meet its commitments in a financial transaction.

Liquidity risk

This refers to the ability to pay financial obligations. This risk may arise when there is a lack of funds to meet operating or investment needs, when there is capital but insufficient liquidity, or when it is difficult to sell assets quickly without incurring significant losses and, therefore, there is not enough money to cover expenses.

Operational risk

Operational risk is when financial losses result from mismanagement, lack of internal controls or staff training, technological failures or human errors that lead to unwanted results.

Legal and regulatory risk

This is related to the risk of encountering litigation, regulatory sanctions or any negative legal consequences. It also occurs when there is exposure to losses as a result of legislative changes and new regulations that affect business operations.

Financial risk management

In a volatile economic environment, entrepreneurs need to be more vigilant than ever when it comes to dealing with these risks. Managing and mitigating them effectively will help ensure financial stability and protect the business. This includes deploying the right strategies and controls, diversifying portfolios, leveraging hedging instruments, and complying with applicable financial regulations. Some of the key aspects of financial risk management include:

• Risk identification. This involves identifying and understanding the risks a company is exposed to through its financial operations. These risks may include market, credit, liquidity, operational, legal and reputational risks.
• Risk assessment. Once identified, their likelihood of occurrence and their impact on the company is assessed. This helps to prioritise risks and determine the allocation of resources to mitigate them.
• Risk mitigation and control. Strategies and controls are implemented to reduce exposure to identified risks. These strategies may include portfolio diversification, risk hedging, use of derivative financial instruments, internal policies and procedures, etc.
• Ongoing monitoring and review. Monitoring risks and their evolution over time is essential because they fluctuate constantly based on economic factors, changes in the industry, regulations and other variables beyond the scope of the company. This is why regularly reviewing and updating risk management strategies is crucial.

Some of the techniques used in financial risk management include deploying tech-driven management tools and, increasingly, artificial intelligence with advanced analytics techniques because of its ability to process large volumes of data quickly and accurately and identify complex patterns.

Researching and analysing market and core business sector information is another key step in mitigating risk, because it makes for more accurate decision making. Anticipating risks through risk management strategies and developing contingency plans will help you prepare for any eventuality, as well as give you an edge over the competition.

Financial risk management strategies do more than just identify the dangers to which the business is exposed. They also have to quantify these risks and predict their impact in an ongoing process that leads to cross-cutting, company-wide responses.