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Finance glossary

What Is Financial Risk Management (FRM)?

Bristol James
6 Min

In the business world, operating without risks is nearly impossible. This is why companies often invest in financial risk management, which give them access to a set of tools and methods to identify, measure, and successfully overcome potential threats.

Identification of financial risk

All businesses will face differing levels of risk. To find a solution for overcoming negative outcomes, business owners and executives must know how to identify potential threats and gauge the level of financial risk. Here are some common types of risks businesses will consider when creating a plan:

Credit risk

In simple terms, credit risk can be defined as the likelihood other companies or individuals may not be able to fulfil their financial commitments. For example, a customer may have entered into a 12-month agreement with monthly payment obligations. The credit assessment calculate or determine the likelihood the customer will be able to make their monthly instalments on time.

Ways to mitigate risk in these situations include running a credit check on the individual. Once you’re ready to enter into your agreement, make sure your agreement is a detailed legal document clearly discussing the terms around payment timing. Further ways to reduce credit risk also include negotiating the contract to ask for more money upfront with a lower monthly fee.

Operational risk

Many companies rely on people, processes, and tech to run seamlessly. Unfortunately, when one of these components fails, even minor errors can become high risk problems.

Operational risk is the loss of finances (and other resources) caused by mistakes or unanticipated circumstances in either the internal and/or external processes.

Fraud, cyberattacks, process management failures – these are just a few examples that can take a business by surprise. In fact, according to the Association of Certified Fraud Examiners, internal fraud has cost companies around $3.6 billion. Companies often look to improve their internal financial controls or invest in cyber security technologies to help reduce operational risk levels.

Market risk

Market risk is an example of an element of risk which cannot be controlled by a business owner and it can be broken into two categories: directional risk and non-directional Risk.

According to The Law Dictionary, directional risk covers the risk of loss arising from exposure to the direction of a reference asset or market. Directional risks are associated with changing stock prices and interest rates. Non-directional risks are based on volatility*.

Legal risk

Legal risk has to do with the likelihood something related to the business will result in legal proceedings. Typically, the construction, healthcare, casino, and retail industries are considered to have the highest risk of civil lawsuits. That being said, companies should always consider investing in legal counsel to ensure they are protected in the event lawsuits arise.

Liquidity risk

In the unfortunate event of a business becoming unable to pay its short-term debt obligations, this is where we look at liquidity risk. Essentially, liquidity risk looks at the likelihood a business still will not be able to repay their debts when they convert their assets into cash. Often lenders will look at liquidity when evaluating risk levels, to ensure if cashflow became an issue, the company could cover it’s debts through liquidation.

Common Factors That Increase Financial Risk

Managing financial risk is not an easy task, mainly because there are many factors to consider. Usually, most of them fall under these two categories:

  • Internal factors: which may include staff issues, underperformance, bad cashflow management, poor investment choices, and more.
  • External factors: which may include changes in market rates, economic downturns, new laws, and more.

Businesses should be prepared with a risk mitigation plan that accounts for both sides.

Strategies for mitigating financial risk

To avoid potential issues with your business operations, you must establish a financial risk management plan.

Risk Assessment

To avoid financial struggles, the first step is to identify and evaluating various risks. The finance team, together with other departments, should go through the company’s financial statements, market indicators, and other factors to assess what could potentially affect your operations. Once you’ve identified potential risks, you can figure out the best solutions.

Risk management tools

As technologies evolve, it’s much easier to manage financial risk. Nowadays, there are many risk management tools available that can reduce some of your team’s workload.

For example, you can use Enterprise Risk Management (ERM) to analyse a wide range of threats and understand the best preventative measures to be taken. These platforms have advanced artificial intelligence capabilities, which means they can do labour-intensive and repetitive tasks more effectively.

If your business works in the finance industry, it can also benefit from automated credit scoring technology. Not only does it reduce the risk of paybacks, but it can also maximise your organisation’s economic performance. Plus – your decision-making will be much more precise.

For businesses dealing with sensitive data or paying several suppliers daily or weekly, other important financial risks to mitigate include those related to cyber security. For example, according to Statista, the global average cost per data breach rose to 4.45 million US dollars in 2023. And this doesn’t even consider the amount lost to the most common cyber scam: phishing.

In these instances, companies should be looking at investing in a cyber security and payment security platform, to ensure data and transactions are accurate and safe.

Risk diversification

All investments include some degree of risk, but portfolio diversification – another risk management technique – can help people and companies alike to reduce their overall likelihood of financial loss.

The idea is simple – remember the saying, don’t put all your eggs in one basket? That’s what we’re talking about. A business should build a portfolio that includes different kinds of assets and investments. In an ideal scenario, this will yield higher long-term returns and offer more protection from market changes.

Although risk diversification is most often used regarding investments, it can also be helpful for businesses in other fields. For example, if your company is focused on providing just one set of products, it should consider expanding into new sectors.

Risk hedging

Another popular risk management technique is risk hedging, which can help reduce risks associated with changing prices, interest and exchange rates, and more.

In a way, hedging is like buying insurance. When you’re going on a trip abroad, you’ll most likely purchase travel insurance so you can protect yourself from unexpected expenses and potential financial risks. Similarly, hedging is used as a measure of caution in finance.

In the event your original investment loses or decreases its value, you have a safety net – which is your investment in other financial instruments that generate profit.

Risk monitoring

Financial risk management is not a one-step process. Once you’ve overcome a challenge or have identified a potential issue, the work doesn’t stop. Risk monitoring is something that should become a part of your business’s regular routine.

If you put in the time and effort to stay aware of changes in the risk environment, you’ll be much more ready to take appropriate action. Remember that unresolved risks often lead to unfavourable occurrences, and that’s not something you want. For this reason, you should view the financial risk management process as one of your business’ priorities.

Every business has and will face disruption

According to McKinsey, companies will experience a serious disruption every two years, lasting between one to two weeks. This may sound terrifying, but only if you aren’t prepared.

Per the 2022 Global Risk Survey, organisations that embrace risk management processes are almost twice as likely to increase their revenue by 11% and more over the next year. Being prepared for risk management certainly pays in the long run.

Even companies with the most thoughtful risk management strategies come face to face with matters out of their control. Macroeconomic shifts, industry changes, fraud – these and other factors can have a huge impact on your business. That’s why it’s so critical to have a proper risk management plan that can help you safeguard your organisation’s finances and prevent it from other losses.

Summary:

  • Key strategies for mitigating financial risk include:
    • Risk Assessment
    • Risk Management Tools
    • Risk Diversification
    • Risk Hedging
    • Risk Monitoring
  • Financial risk management is something every business should be investing in.
  • Having a risk management framework reduces the likelihood of potential financial losses, ensure your compliance with regulations, help you with planning and provide many other benefits.
  • In the long run, companies constantly assessing and monitoring financial risk are proven to generate more revenue over time than those who don’t.

 

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