How to assess financial risk

Applying an effective risk management approach can help you better understand and plan for the financial risks that can impact your business. Effective financial risk mitigation strategies help minimize threats to your growth and success.

What is Financial Risk

Financial risk refers to the possibility of losing capital on a business, investment, or lending decision. Virtually every profit-seeking venture involves some degree of uncertainty – but this uncertainty can be managed through a variety of risk mitigation strategies.

Cash flow – the money coming in via accounts receivable and going out via accounts payable – is the lifeblood of your business. Cash flow is affected by certain financial risks that have the potential to create sudden losses and make it difficult or impossible for you to manage your business’s financial obligations. Those risks can include clients not paying you, changing market conditions that could affect how you conduct your business, and mismanagement or technical failures that can affect your revenue.

When you perform a business risk assessment, you can evaluate your financial risk level from multiple angles. Basing business decisions on those findings can help reduce the possibility of these risks impacting your business.

What Are the Different Types of Financial Risk?

Effective risk mitigation starts with understanding the various types of financial risk that businesses face. Here are four key examples:

• Market risk refers to the ever-changing business environment and how that environment affects how you do business. Examples of market risk include how online shopping has affected traditional retail businesses and how the internet has affected print newspapers.
• Credit risk is the risk that comes from extending credit to a client who does not pay. This can disrupt your cash flow and reduce your profit.
• Liquidity risk refers to the inability of a company to quickly convert its assets to cash if a sudden need for cash exists. It also refers to a company’s inability to meet its financial obligations.
• Operational risk is the risk that operational failures – such as mismanagement, fraud, business model failure or technical issues – will affect the performance of the business.

How to Mitigate Financial Risk

Today, many businesses treat financial risk as an accounting issue that can be addressed during the annual budgeting process. But financial risk can impact any aspect of your enterprise at anytime, so it's essential to develop risk mitigation strategies that are holistic and continuous.

Here are five best paractices to consider:

Assess Business Operations

Some elements of financial risks, like market forces, are outside your sphere of influence. That means it's crucial to proactively mitigate the risks that are within your control.

Management experts recommend ‘deconstructing’ your entire workflow to identify hidden costs, inefficiencies, and vulnerabilities – as well as new opportunities for revenue generation to hedge against external risks. You can start with an organizational chart and break your process down into detailed checklists.

Nurture Your Talent

Today more than ever, employee turnover is a significant driver of financial risk – especially in sectors where customer relationships are paramount. When an experienced team member departs, it can undermine client confidence in addition to incurring recruitment and training costs. That’s why the true cost of turnover can be measured in months, if not years, of salary.

Increasingly, business owners are viewing employee retention as a long-range risk mitigation tactic, investing in supportive work environments and professional development opportunities so employees don’t have to go elsewhere to advance in their careers.

Create a Strong Foundation for HR & People Teams

While often overlooked by conventional risk mitigation models, employment practices can play a major role in financial risk. Consider the potential impact of a lawsuit over wrongful termination, harassment, or wage violations – there could be significant legal expenses as well as serious harm to productivity, morale, and public goodwill.

To manage these risks, businesses are prioritizing robust HR practices, including comprehensive handbooks, training programs, and diversity, equity, and inclusion (DEI) initiatives.

Make Decisions Based on Data

When financial risk is involved, it’s not enough to simply operate on intuition. Successful risk mitigation strategies leverage metrics – both to assess past performance and to anticipate future outcomes.

Whether they’re looking to launch a new product, make personnel changes, or expand their footprint, business owners are increasingly making use of key performance indicators (KPIs) and forecasting tools before they take action. And while hard data is important, it can also be valuable to collect qualitative insights like market sentiment and employee engagement.

Be Prepared to Cover Loss

It’s important to reduce risks whenever possible, but it’s just as important to expect the unexpected. It could be a supply chain disruption, a cybersecurity breach, or a liability claim – but whatever the cause, you’ll need to have a plan for covering the loss.

In addition to an adequate cushion of working capital, insurance is an essential component of any comprehensive risk mitigation strategy. In addition to maintaining general and professional liability coverage, you should assess your business’s specific risk profile and determine if additional types of insurance may be warranted.

How Do You Conduct a Financial Risk Assessment?

Financial risk is a constant in every business and the best way to manage that risk varies from industry to industry. A financial risk assessment can help you identify the risk levels specific to your business, prioritize those risks, develop ways to avoid them and outline steps to manage them should they happen. A financial risk assessment also helps you understand your appetite for risk.

To develop financial risk mitigation solutions, you will need to identify and analyze financial risks, then create a proactive financial risk management plan.

Identify Financial Risk

Some financial risks are common to all ventures, while others may be dependent on your industry or even your individual business practices. The first step in developing a sound risk mitigation strategy is pinpointing the particular financial threats and opportunities that your business faces.

By identifying financial risks, you can take a proactive stance in protecting your business’s cash flow and improving performance. To identify financial risk, start by carefully reviewing your corporate balance sheet or statement of financial position. You will want to understand what your main sources of revenue are and how customer credit terms affect this revenue. For example:

• Check how cash flow fluctuates over time and how your revenue growth compares to last quarter and last year. What has impacted growth?
• Review your short- and long-term debt. Determine what the effect would be if interest rates rise.
• Identify any clients who represent more than 10% of your total revenues. These could put you at risk if they are unable to pay their invoices. Learn more about Allianz Trade trade credit insurance solutions that can protect you from this risk.
• Carefully review your client segments by geographic region. What financial risks are inherent in these regions? You can learn more about international trade risks from Allianz Trade.

Analyze the Financial Risk

Once you have identified financial risks, you can begin analyzing each risk to determine the likelihood of the risk occurring and its consequences.

First, check how consistent you are in producing profit. A healthy profit margin allows you to absorb any hits to your cash flow that you may discover in your analysis.

Then, analyze each financial risk by asking these questions:

1. What is the likelihood of this risk occurring?
2. If this risk occurs, how much of an impact would it have on the business?
3. If this risk impacts the business, what steps can the business take to recover?
4. What can the business do to prevent this risk or prepare in advance of the risk occurring?

By analyzing the risks, you can clearly see which are priorities to address, and better understand what needs to be outlined in your risk mitigation plan. Depending on your business, you should identify and analyze risks quarterly, semiannually, or annually.

Create a Proactive Financial Risk Mitigation Strategy

Once you analyze your business’s financial risks, you can plan how to meet those challenges in cost-effective ways. Select appropriate controls that can help you mitigate identified financial risks or manage them should they happen. Document the controls, identify which controls should be applied to which risks, how they should be applied and when.

Depending on when you conduct your regular risk identification and analysis exercises, you should also update your financial risk management plan.

Contact Allianz Trade for more information related to financial risk mitigation and solutions for your business.

Frequently Asked Questions about Financial Risk Mitigation Strategy

What is a financial risk mitigation strategy?

A financial risk mitigation strategy is a systematic approach to reducing and preparing for potential losses of capital due to internal and external threats. By implementing these strategies, businesses aim to safeguard their assets and ensure long-term stability.

How do you develop a financial risk mitigation strategy?

The first step in crafting a financial risk mitigation strategy is identifying the specific risks that your business faces. Then, you’ll need to take steps to reduce those risks and plan to cover potential losses with emergency funds, additional revenue streams, and appropriate insurance coverage.

Why do you need a financial risk mitigation strategy?

Businesses of all sizes, types, and ages need effective risk mitigation strategies to understand, manage, and prepare for threats that could impact their cash flow and long-term success.