What is financial risk: types and tips for dealing with it

In a market like the present, not shouldering financial risk would appear to be impossible. In this sense, as Mark Zuckerberg points out: “Not taking a risk is the biggest risk of all. In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks". 

The fact is that financial markets constantly face multiple types of financial risk stemming from a variety of macroeconomic factors. That's why it's vital to understand what is financial risk, the dangers and how to protect yourself. Although this won't eliminate the risk in itself, as it's linked to uncertainty about what may happen in the future, it can mitigate the damage and reduce the chances of a negative result.

What is financial risk?

When we describe what is financial risk, we mean any business activity that implies uncertainty and that, therefore, might lead to negative financial consequences for an organisation. Such a situation may lead to a loss of equity.

Financial risk is linked to a company's profitability. So, for example, the more debt a company has, the greater the potential financial risk. For this reason, before making an investment, it is essential to calculate any risk involved.

Types of financial risk

The main types of financial risk are market, credit, liquidity, and operational risk. Below we look into each of them in more detail: 

Market risk

Market risk arises when there is a loss in the value and position of a company asset due to market fluctuation. In other words, this type of financial risk is generally associated with a change to pricing or customers' consumption patterns.

So, this is a form of financial risk that stems from economic uncertainty in the financial system itself, which can affect the performance of both a specific company or a group of them. 

There are several types of market risk:

• Exchange risk: this occurs when making investments that involve an exchange of currency; hence the importance of making sure that the currency is stable and not at risk of depreciation.
• Interest rate risk: connected to the rise and fall of interest rates.
• Market risk: this refers to a change in value of stocks, bonds, etc.

One example of market risk would be what a company faces when it opens up in a country with rampant inflation, as the company would need to deal with high interest rates in its transactions.

Credit risk

Credit risk is about the inability of one party to pay its debt in accordance with contractual obligations. 

An example of credit risk would be that experienced by a company faced with non-payment, i.e. when one of its clients fails to pay for their service and the company has to cover that decrease in cash flow by writing off the expenses of the service provided. Meanwhile, if the client cannot make the payment on time, the company will have to file claims against them, losing time and money in the process.

Operational risk

Operational risk occurs when there are financial losses due to mismanagement, a lack of internal controls within the company itself or of staff training, technological failures or human error that affect commercial production or lead to unintended results. 

This type of financial risk is what happens, for example, when using software that isn’t up-to-date or, conversely, when the necessary training is not provided to staff to ensure they are up-to-date with any innovations or changes to the systems. In both cases, the company may face a series of problems, such as system crashes, or cyberattacks. 

Liquidity risk

Liquidity risk is connected to the ability to settle short-term financial obligations. Here, every organisation has to ensure they have sufficient cash flow to pay off their debts. 

However, it should be kept in mind that a company might have a significant level of equity but, at the same time, a high liquidity risk if it cannot convert those assets into cash to cover its short-term expenses. 

What is financial risk: pros and cons

Accepting risk is vital in business; it's what drives growth and profitability. Moreover, understanding what is financial risk can lead to making better informed business decisions or investments. This is because financial risk, in itself, is neither good nor bad. Rather, depending on the circumstances, it entails certain pros or cons. 

Pros

The main advantages of financial risk are as follows: 

• Growth: by taking certain risks, a company may perform better and therefore generate more revenue, which in turn leads to its growth and expansion.
• Tax planning: the losses incurred by a company can be used to obtain a tax deduction, which can be spread over several years. 
• Alarm-bell for investors and managers: financial risk is a warning for investors and managers to take action.
• Valuation assessment: the financial risk inherent to certain businesses or projects can help to assess income using the risk-return ratio. 

Cons

However, financial risks also have many disadvantages. Amongst others, the following are of note:

• Likelihood of catastrophic outcome: failure to make payments can cause lasting damage that may lead to the company going bankrupt. 
• It cannot be controlled: many types of financial risk arise from global factors, natural disasters, wars, etc., which cannot be controlled.
• Long-term effects: if financial risk is not managed at the right time and using the right strategies, it may damage the company's finances and reputation. Likewise, it may have a knock-on effect on the entire sector, market and economy.

How to measure financial risk

One of the advantages of new technologies is that it's only getting easier to measure financial risk. In fact, according to Ben Fidlow, leader of the global Core Analytics team, the Risk & Analytics Department of Willis Towers Watson, thanks to Big Data, the ability to quantify risk is up to 10 times greater today. Moreover, according to the Gini Index, big data technologies and Machine Learning have increased the ability to detect credit repayment problems by 60% to 90%.

Besides the major help that technological advances imply, there are other ways to measure financial risk, consisting of assessing the following areas: 

• Debt-to-asset ratio: how much the company owes and how much it earns.
• Debt-to-income ratio: this is measured by dividing the net or gross debt by the revenue or gross profit (EBITDA).
• Debt-to-equity ratio: this involves analysing the asset ratio in an organisation financed with debt. It’s similar to a debt-to-equity ratio and is measured in the same way: mathematically.
• Interest coverage: calculated using the utility formula or EBITDA, divided by the interest.
• Cash flow and debt: the cash flow available for debt service is measured and divided by the debt. 
• Equity multiplier (financial leverage multiplier): calculates the ratio of total company assets financed by its shareholders. 

The importance of knowing how to manage financial risk

Financial risk management is an essential element in any company's success, as it helps us prepare to take advantage of opportunities and anticipate or foresee any situations that may lead to economic losses. 

The main ways to manage risk are: 

• Identifying the source or cause of financial risk.
• Analysing the impact of financial risk for the company.
• Drawing up plans and strategies to mitigate risk.

In this situation, it is essential to have a team of well-trained professionals, i.e., who have the necessary tools and know-how to be able to understand what is financial risk and apply the main mechanisms that allow financial risk to be managed. 

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