What is Financial Risk And Types Of Financial Risk

There are many major factors that can cause turbulence in the finance system of companies. These factors can cause financial risks and some common examples of the same are foreign exchange rate volatility, fluctuating interest rates, and the price uncertainty of commodities. On the other hand, there are many tools that were designed to handle these risks but they have also become so complex and challenging for organizations to understand and contemplate. Financial reporting has become equally hard because of the certain standards that are followed around the globe. So overall, the risks are hanging for all the organization. But there are certain things that can be done to deal with it. In this article, we are going to learn all about financial risks, the classification of risk, and much more. Furthermore, we will provide information for project management professional certification so that you are very well equipped with the knowledge and skills.

What is financial risk?

The financial risk in any company is referred to as the possibility of losing money in the business or any kind of investment. If we put it in another way, this means the danger that can happen when there is a loss of capital. The cash flow in the company might seem insufficient to meet its obligations with it in the case of risk. There are many common financial risks: foreign investment, credit, and operational, legal, equity or liquidity losses.

The financial appetite is different for different bodies and on this page, we are going to discuss what these financial risks mean to different segments in a society like government, businesses, individuals, etc. This will give you an idea of what are the causes or factors that cause financial risks and what could be measured can be placed in order to avoid those risks.

What are the types of financial risks?

There are 4 types of financial risks majorly:

1.       Market Risks

2.       Credit Risks

3.       Liquidity Risks

4.       Operational Risks

Let us understand them one by one now.

Market Risks

This is one of the risks kinds that has a very broad scope and it is one of the crucial financial risks. The main reason it appears is because of the dynamics of supply and demand in the market. There are so many things that make or break the market and there are a lot of uncertainties that are involved with the market economics that it does not only affect one company but all the companies that are in the market get affected. Some sources of these risks are assets, liabilities, and derivatives. This can be understood with the help of an example- when an importer is paying for its supplies in dollars but then has to sell the final product in the local currency, due to its devaluation, the company might suffer a loss and it will prevent them from fulfilling its financial obligations.

Also, in commercial sectors, due to the huge rise in e-commerce, the companies that have adopted online sales and purchases are seeing a huge rise in their revenues as compared to the companies that are still lacking this competitiveness. You can learn more about risk management in your online PMP training.

Credit Risks

Credit risk is one risk type that plays a huge role in financial risk planning. In this risk, there is a possibility that the creditor is not going to receive the loan payment or going to receive it very late. So in this case, if it becomes their obligation to fulfil their payment obligations then Credit risk is divided into two types furthermore: retail and wholesale. In the retail type of credit risk, we can find the credit risks involved with small businesses or financial individuals. This can be through mortgages, cards, or any other type of credit.  But if we talk about wholesale credit, this belongs to the organization’s own investment and this includes assets, mergers, and also acquisitions of these companies. There are some examples where we can see these kinds of risks in the market and it is very important to study these types of financial risks.

Liquidity Risk

If we are planning financial risk management, then we should always take the possibility of liquidity risk in mind. The companies need to make sure that they have enough cash to pay off their debts because if they fail to do so this might ruin the investor confidence. There could be a possibility that the company is not able to fulfil its commitment and this indulges them in poor cash flow management. It is possible that the company might have a large share of the equity but at the same time, they do not have enough liquid funds for them. This will be a risk for them. This risk is more prominent because those assets cannot be converted into money to meet short-term expenses. Some examples of long-term assets are real estate or bonds and they might take longer to get converted into cash.

Operational Risks

This is the last one but an important one. There can be various types of operational risks. The common cause of these kinds of risks involves ambiguities in internal management, technological failures, mismanagement, lack of training, and human errors as well and eventually, these things will lead to risk for the companies. They can be hard to find and work upon, so to make sure that the companies are able to overcome it, they should have a history log where that can have records of failures, their measures etc.

Now that we are aware of the financial risks associated with the companies, let us understand the financial risks for various sectors.

Financial Risks for Businesses

There is no doubt in the fact that business faces risks. There are major factors that play a role in this like macroeconomics forces, fluctuating market interest rates, influences from a particular sector, and much more. Small businesses might feel at risk when they are making decisions that could affect them when paying their debts or income. Building a business from the scratch is expensive and for this, the businesses need loans and capital. So there is always a risk associated with this. They need money from their investors/stakeholders to run the company’s business and maintain steady growth. If there is any withdrawal that comes that a bad time, this will put the company at a greater risk than expected. There is always the risk of credit risk when there is some credit involved.

Other types of risk that are associated with companies are specific financial situations. This could relate to capital structure, issues with financial statements and transactions, etc. There could be uncertainty about collecting returns and potential monetary loss. These risks can come in various shapes and sizes and businesses are very vulnerable to the mentioned financial risk types.

Understanding financial risk for the Government

Each and every policy of the government is going to affect the finances of the country. There are many financial risks associated with the government. This can be them losing control of their monetary policies, or not being able to control the inflation in the country. They might also be in default on their bonds or other debt issues. There are various places where the government issue debt to fight wars, make bridges, and other infrastructure for the public along with pay for the government workers. The governments are always at risk of issuing defaulted debt. Sometimes, these entities to which the government has issued debt delay the payment or do not pay the full amount this causes a risk to the investors and the stakeholders involved in this.

Financial risks for the Market

The markets are very influenced by the factors surrounding them and they can incur risks very often. Whenever there is some struggle in the marketplace from a particular sector, the whole marketplace usually suffers. There are many things like the volatility that have a great impact on the market. This is part of the stock market share which is seeing a rise and decline every now and then.

Market interest rate changes and defaults can pose financial risks. Defaults occur mainly in the debt or bond market when issuers or companies fail to pay their debt obligations. Asset-backed risks arise when asset-backed securities become volatile when the value of the underlying securities also changes.

Financial risks for individuals

There are many factors that can cause risks for individuals and this can be based on poor judgment calls and some things that are not in their control. There is always a risk associated with your investments and when they are putting money somewhere they need, under the potential risk that might come with that. The profits and gains might have an uncertain success rate for those investments. If they are not doing their proper research then this can lead to risks. The financial risks happened to the individuals that go too far for the gains and they are not aware of their net worth for that particular investment.

How to identify financial risks?

There are many factors that you can look for if you want to identify risks. Some of those are:

1.       Knowing what are the risk factors that could incur a financial risk for the company is very much needed and there should be a risk management plan already in place to deal with that.

2.       When businesses are reviewing their balance sheets, they can come across various factors that could be causing risk to their company.

3.       There are various financial statements available in the business, so studying those statements of financial position will give an idea of the same.

4.       A company that is aware of the risk and its operations can explore various things to mitigate those risks. So always keep on exploring those plans.

5.       Also, doing the comparisons of various metrics with other companies in the same sector will also give you an idea of where you are standing and what is lacking.

6.       There are technical advanced statistical analysis techniques that could help in discovering the risk areas for the company.

How to handle financial risk?

When there are financial risks in the company, they can be mitigated but it becomes very expensive to completely eliminate those financial risks for the company. If the companies are going for the right amount of insurance, diversifying the places where they are investing, and also having a good cash flow that they can use for funds for emergencies then they can be on the safe side. Also, making sure they maintain various kinds of income streams will be helpful in handling their financial risks for them. With these things, they can manage their various finances and reduce the impact of risk on their businesses.

Benefits of using financial tools and teams

There are some great advantages that come with using financial tools and dedicated teams in your corporation.

Monitoring Funds

If the fund monitoring is going on a real-time basis then the company is aware of how much they are making, how much they are spending, what their assets are and what is the situation of the cash flow. This monitoring will keep them aware of the real-time situation. This will help in keeping the budget on point and avoid wasting the budget too.

Prevents fraud

Frauds are common in financial sectors, but with the help of various tools and monitoring, you can manage the risks as well as prevent fraud. These tools keep a record of all the transactions and this will prevent fraud. You can quickly freeze the amount if you are seeing some fraudulent activity on the account.

Transparency

One of the most important factors which are needed when there is a financial management plan needed is transparency. If their funds and transactions are clear then there will be lesser chances of risk. The audit trail will help in finding that risk. There should be documentation, statements and much more so that the companies are able to find the inconsistencies and reduce the possibility of risk altogether.

Summing up

We have now understood all about what is financial risk, its types, its effects, and much more. This is the kind of risk that everyone dreads. So with the right plan in action, this can be reduced. Nowadays companies are really investing in this area to avoid these risks in their businesses. There are many real-world examples that will help you understand managing financial risk and with that, you can see how those companies managed them and overcame those crises.

If you are interested in knowing about it more and want to get a career in managing and evaluating projects in the team, then it is best to get certifications for the same. There are some of the best places where you can go for your project management professional certification and get the PMP training, but we would suggest going for the best platform- StarAgile. Here you can find all the course material that will help you with the certifications and once you have enrolled in the course, you are going to find ample opportunities for your career. So start now and find the best career path for yourself.