Effective financial risk management plays a key role in the creation of stable revenues from business activities, in particular in terms of stable funding and adequate hedging of external market risks. Conduct regular risk assessments so you are always aware of the risks to your business. Knowing your risks will help you assess the best options and create plans for risk mitigation.
Stress testing is a tool that can improve your risk management and raise the level of confidence in business planning and forecasting. It is a complex activity which requires pulling together knowledge, competencies and infrastructure across the business.
Establish economic metrics that are simple and adaptable to challenging environments. Use these metrics as KPIs for future testing. Ensure stress testing is refined continuously based on new intelligence and risk identification, such as the crisis lasting longer than expected or customer and supplier disruption.
Types of risk
There are different types of risks to your finances. The most common and distinct financial risks include credit risk, liquidity risk and operational risk.
Credit risk arises principally from the business loans and receivables presented under financial fixed assets, trade and other receivables, cash, and the positive fair value of derivatives. Offering your customers credit means providing goods and services without immediate pay. Depending on your bilateral agreements, your customers will have a certain amount of time to pay you for goods or services. Allowing your customers to buy on credit will generate more sales, as it will help your customers with their liquidity management.
Credit risk is a risk that one party to the agreement will cause a financial loss for the other party by failing to meet its obligations. If your customers are not able to pay for the goods or services you provided, or are late with their payments, it could have potential consequences for your business operations and cash flow.
A business’s liquidity is measured by the time a business needs to get to cash. There is market liquidity and operational liquidity. Market liquidity refers to how fast a business can sell certain assets if it finds itself in immediate need of funds. Operational liquidity refers to everyday operations and the cash the business has for these.
• Not being able to convert assets into cash is considered a liquidity risk.
• A business that does not hold liquid assets is risking having to sell those assets at below the market price in the case of an emergency.
Managing liquidity risk is very important for your business. Liquidity risk is unavoidable, so it is essential that your business manages it successfully. Your business should monitor its cash position by using successive liquidity budgets. On the other hand, management needs to ensure that the cash position is sufficient to meet the financial obligations towards creditors and to stay within the limits of loan covenants.
Business should always be aware of their liquidity risk. By comparing assets and liabilities, you can forecast how much money you might owe if something goes wrong and compare it to the available assets and their liquidity. Define scenarios that address global slowdowns and model cash flow.
Operational risk refers to your potential inability to cover your operational expenses. Unlike credit risk and liquidity risk, operational risk does not come from revenue changes but from unexpected business activities. To learn more about operational risk and how to manage it, follow this link.