Financial Risk Definition and Its Types
Risk can be defined as the probability of an unexpected negative event or occurrence. In the world of business, companies may take risks voluntarily to increase their profits. However, in some instances, external factors like stock market fluctuations, politics, or even the weather can put a company at risk.
Financial risk can be classified as a separate risk type in business, taking traits from both systematic and unsystematic risk types. Systematic risk can mean the general risk of the market, whereas unsystematic risk is usually company-specific.
In some cases, the threat of financial risk can be predicted and mitigated. Familiarizing yourself with the types of financial risks can help you recognize them. Additionally, understanding financial risk examples may aid in managing them.
What is Financial Risk?
Financial risk is any occurrence that can potentially cause financial loss. Companies and individuals make financial decisions knowing that there’s a chance it may impact their income negatively. For example, financial risk can include losing money on an investment due to stock market volatility.
Financial risk and money loss can come in many forms. For example, governments can risk their ability to control the monetary policy of the country. Banks can risk the possibility of failing to pay interest to the depositors. Companies may also risk losing revenue after an extensive marketing campaign.
There may be other macroeconomic factors that can jeopardize the financial situation of a company. For example, changes in market interest rates can cause credit organizations to lose revenue. Or, an economic collapse may force some firms to sell assets to pay salaries and continue operations.
Financial risks are everywhere, and there’s hardly any organization that doesn’t have to deal with them. Unfortunately, these risks can sometimes be increased due to poor cash flow management or excessive debt. Acknowledging these risks and knowing how to control them may not eliminate them, but it can reduce the negative impact on financial statements. For a better understanding, let’s take a look at the most common types of financial risk.
Types of Financial Risk
This section will explore five main types of financial risk - market risk, credit risk, liquidity risk, operational risk, and legal risk. It’s important to know the types of risk in finance to tackle them in the future.
Market Risk
Market risk (also known as systematic risk) is the probability that an entity or an individual may face losses because of changes in the entire market. Common events that can lead to market risk are recessions, stock market volatility, or currency fluctuations. However, other causes can also include political unrest and natural disasters. Usually, when these factors occur, many organizations are simultaneously affected.
For example, a foreign merchant can buy goods from a U.S. seller and import them to their country. The merchant buys these products in dollars, sells them in their local currency, and earns a markup from currency conversion. However, if the foreign country suffers from political unrest, its currency can depreciate. As a result, the merchant can encounter losses due to currency fluctuations. Moreover, the U.S. seller may also be affected due to exchange rate depreciation. Consequently, the U.S. seller can lose money due to political unrest in a foreign country they conduct business with.
Interest rate risk is another example of market inconsistency that can affect a corporation’s security values. For instance, a corporation may have invested in bonds that offer a fixed 5% interest rate. However, The Federal Open Market Committee (FOMC) may raise the market interest rate to 7%. This market change can cause the corporation to lose money on its investment due to a decline in demand.
The unpredictability of market risk makes it difficult to protect against. However, there are still some hedging options that companies can utilize to soften the punch. Investors can insure their assets by purchasing put options, which allow them to sell their securities at a predetermined price within a specified time frame. Even if it’s meant for temporary use, it can stabilize the investor’s financial situation in case of an unexpected fluctuation.
Credit Risk
Credit risk (or default risk) is the likelihood of a borrower’s failure to repay a loan or meet other contractual obligations. It is the risk that any lender may not fully or partially receive the principal lent amount plus interest. As a result, disruptions can occur in the firm’s cash flow that may translate to financial losses.
Banks, credit organizations, and private lending individuals face a certain degree of credit risk in every transaction. There are two main types of credit risk - retail and wholesale. Retail credit risk usually accompanies mortgages, credit cards, or any other type of credit. Even though credit applicants typically go through an extensive verification process, lenders can never be entirely sure about the applicant’s punctuality and creditworthiness.
Wholesale credit risk concerns an entity’s investments. It can arise from the sale of financial assets, as well as from mergers and acquisitions. Accounts receivable may accumulate on an organization’s balance sheet, which can cause doubts about their timely repayment. For example, a company may deliver products to a customer who promises to pay by the end of the year. Although the customer has agreed to repay the company for the product, they may be unable to fulfill their obligations. As a result, the company may suffer financial loss if they have excessive outstanding payments from customers.
The Financial Crisis of 2007 and 2008 is an infamous example of how credit risk affected the global financial system. Banks issued excessive subprime mortgages to thousands of unemployed people or individuals with low-income levels. A subprime mortgage is a relatively high-interest loan issued to borrowers with a lower credit rating. As a result, subprime loans are higher-risk loans for lenders and borrowers. Intending to increase their income, banks liberally approved applicants. However, many borrowers ended up defaulting on their loans, causing lenders and investors to lose money they had extended or invested. As a result, many banks were forced into bankruptcy, unemployment soared, and security prices plummeted drastically.
Liquidity Risk
Liquidity refers to the ability of a company to pay off its debts without facing significant financial losses. Liquidity risk refers to the inability to buy or sell assets to meet short-term liabilities. Liquidity and the risks associated with it usually revolve around cash. As cash is the most liquid asset, companies classify other assets in terms of how fast they can be converted into cash. Some of the less liquid assets include real estate, equipment, and sometimes even bonds.
Let’s say you have a house worth $250,000 that you would like to sell. You need fast cash, but if the real estate market is currently down, you may not be able to find buyers quickly. It may take a year or more until someone agrees to buy the house at that price. Since you need to cover your short-term expenses, you may be forced to sell it at a lower price and lose money in the transaction.
It’s essential to always keep an eye on a company’s liquidity level. A firm may have a lot of equity but face high liquidity risk because most of its equity would take a long time to sell. Usually, investors and creditors measure liquidity by calculating liquidity ratios, such as the current ratio, quick ratio, and cash flow ratio. These show the real-time standing of the company’s assets. They give an overall picture of the available liquid assets and provide ground to managers for making financial decisions.
Legal Risk
Legal risk refers to any loss that can arise from legal action. Legal risk involves the failure to meet legal requirements, such as paying taxes or filing an annual income tax return. As a result, companies may be required to pay heavy penalties for non-compliance.
Legal risks can also include lawsuits filed against the company. For example, a competitor may sue for copyright or trademark infringement, which can lead to significant financial loss. Lawsuits can also be filed against a company by stakeholders, suppliers, customers, or employees. As soon as these issues arise, it’s crucial to resolve them before they reach legal proceedings.
Operational Risk
Operational risk stems from instability within the company concerning its day-to-day operations. For example, operational risk includes mismanagement, human error, or technical problems that can cause financial loss. As opposed to market risk, operational risk can be classified as unsystematic risk, as it’s unique to every company and may not necessarily harm anyone outside the organization.
Operational risk can be one of the most challenging forms of risk to calculate. To manage it effectively, the company needs to collect data about previous failures and find common patterns to avoid repeating them. It’s also essential to trace the original cause of the risk. Usually, these risks can cause a chain reaction in the company and create other hazards. For example, if a machine breaks down in one department, it not only hits the company’s budget but can also slow down production and cause a delay in the delivery of certain products.
Human error can be one of the leading causes of operational dysfunction in the organization. But there are also cases where employees get involved in fraudulent activities and damage the company’s reputation. A famous example is the case of Riggs Bank when an employee in charge of Equatorial Guinea accounts was involved in money-laundering schemes. He allegedly created a fake holding account in his wife’s name overseas and transferred funds into this account. This, combined with other mismanagement issues, eventually made the company go defunct.
How to Manage Financial Risks
If you ask a financial advisor, certain investments can be riskier than others. Unfortunately, if you’re in the world of business, there is almost no way you can completely avoid risk. However, thanks to financial risk management, you can at least measure them to manage and mitigate. Additionally, risk management can help you prepare safety plans and hedge against risks.
To manage financial risk properly, the first step is to analyze the risk. Risk analysis is the process of determining and assessing the probability of a negative outcome for any company undertaking. There are three main ways of analyzing the risks associated with long-term stock market investments:
- Fundamental analysis - evaluating the intrinsic value of a security by taking into account all internal and external factors. Fundamental analysis usually starts by considering the overall state of the economy, then focuses on industry-specific implications. It then looks at the individual company’s sales and earnings and finally comes up with an aggregated risk level.
- Technical analysis - assessing historical data, such as trade volumes, stock prices, and the returns from each investment. This method prioritizes past trading patterns. It implies that studying past price changes in securities can deliver valuable information about their future performance. As opposed to fundamental analysis, technical analysis does not assess risk based on the company’s financial standing.
- Quantitative analysis - estimating risk using relevant financial ratios. For example, it provides insight into the company’s financial leverage by measuring the debt-to-equity ratio. The debt-to-equity ratio refers to the proportion of debt a company is liable for in relation to the amount of capital it has. Another commonly used ratio is the capital expenditure ratio, which is cash flow from operations divided by capital expenditures. It shows how much capital the company will have left after paying off all its debts.
When it comes to taking action to protect against these risks, experts suggest the following practices:
- Diversification. One of the most common and effective ways to minimize risk is by spreading it among different investments. Diversification suggests purchasing different types of financial instruments instead of creating a portfolio with only one or two types of securities. One drawback is that diversification does not hedge against market risk. However, it does eliminate some unsystematic risks, such as operational and legal risks.
- Using a Savings Account. Businesses and individuals can consider opening a special account for emergencies. A savings account ensures that you have cash at hand for any given situation. For example, a savings account can hedge against liquidity risk. In times of trouble, it can provide you with cash when your other assets take a long time to sell.
- Acquiring Insurance Policies. Insurance policies protect businesses and individuals from damages or unexpected events. For example, business liability insurance can offer legal protection to the company in case of a lawsuit, thus reducing the possible effects of a legal risk. Professional liability insurance can secure against losses due to negligence and mistakes. And property insurance offers assistance in case of damage to the company’s building and equipment.
Key Takeaways
When we talk about financial risk, we refer to the possibility of losing money. Individuals and organizations all face risks, most of which they can measure and mitigate. Some risks arise naturally from actions taken by the company or the individual. Others are caused by external factors and may affect the whole industry.
A typical organization faces five major types of financial risk. Market risk does not usually depend on the company’s actions and cannot be eliminated with traditional methods, such as diversification. Operational, credit, liquidity, and legal types of financial risk typically arise from the company’s actions. At times, they can threaten the company’s solvency and future existence.
With fundamental, technical, and quantitative analytics, risks can be measured and assessed. Purchasing insurance policies and creating a savings fund can help you minimize the effects caused by instability.
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