What is Financial Risk Management?
Financial risk management is the reduction of business risks or uncertainties as a result of financial planning. It is the identification, evaluation, and mitigation of potential risks in order to achieve the desired objectives.
According to Fintalent’s financial risk management consultants, the primary goal in business finance is to efficiently manage a company’s risk exposure so that it can survive and thrive while minimizing risks and protecting the value of its assets. There are several different tools that allow managers to assess their firm’s financial position including budgets, forecasts, profit-and-loss statements as well as calculation methods such as return on investment (ROI) analysis.
Best practices include having an accurate understanding of risk factors which includes identifying key events and trends (e.g. a sharp rise in the cost of labor, the conversion of a product from generic to a more expensive brand) and common sources of financial risk (e.g. fluctuations in commodity prices, competition, changes in legislation).
Financial risk management consists of three distinct processes:
The first step is cost identifying, as one does not know what the true costs are for certain factors such as a new product, or changing packaging styles. The second step is assessing the likelihood of them occurring. The third step is determining whether additional actions are needed to increase or decrease their likelihood (e.g. purchasing additional insurance against an unexpected catastrophe). Exercising control over these risks will allow companies to achieve the goals they set out with their business plan.
Protecting the company from unforeseen risks and ensuring its future in the long-term are key elements of financial risk management, but these actions cannot be done without careful monitoring of key financial indicators.
Financial risk management is an overarching term that encompasses many different methods of identifying and controlling various business risks. It is about taking control over a firm’s future, thus allowing it to grow, rather than just simply surviving on a day-to-day basis.
There are many different tools that can be used to analyze financial data including budgets, forecasts, cost-benefit analysis and cash flow projection. These tools, however, are only as good at predicting risk as the person using them.
The first step in risk identification is to determine the magnitude of potential risks faced by a company and their potential negative impacts on financial performance. These could include an unforeseen rise in the cost of raw materials and labor (e.g. if a new product requires substantial labor hours or costlier chemicals, it may affect a company’s profitability).
Once risks have been identified they must be evaluated to determine how likely or unlikely each one is. This is done using different techniques based on their characteristics and the type of company being assessed (e.g. if a company’s product is popular with teenagers and the market changes, its financial risk may increase).
Once the risks have been fully evaluated, the probabilities can be expressed as a numerical value or as a probability curve.
This can then be used to calculate potential losses or benefits that could be realized from taking certain actions. For example, if a company is considering purchasing new equipment to process a product that it has recently changed its packaging for, increasing production costs could be considered one of many possibilities. Instead of purchasing more expensive equipment, companies might also consider whether they should hire new employees or take other actions to reduce costs.
The third step in risk management is to determine if additional steps should be taken to either increase or decrease the likelihood of that risk occurring. This can be done by taking measures such as increasing reserves, reducing debt levels (e.g. not increasing inventory), getting additional insurance, avoiding certain contracts and partnerships, etc.
These three steps allow companies to effectively manage their financial risks and ensure the safety of their business and its future success in the long term.
Once risks have been identified, assessed and determined to be either inevitable or avoidable, the company must then plan on how to deal with them.
Planning can be done in many different ways depending on the company’s financial situation. For smaller companies that are just starting out, a cash flow projection will allow firms to project future cash flows which can then be used to analyze the impact of potential risks (e.g. a $25,000 loss if raw materials prices rise). This helps companies identify those kinds of risks that are most likely and thus allows managers time to take further steps to offset their negative impacts.
For businesses that have been around for a while, cash flow projections may not be as helpful. In these cases estimates of potential losses or benefits can be made by using a three-step process (cost-benefit analysis). First, companies can assess the costs that would be incurred from the risk occurring (e.g. increased labor hours, higher raw material costs etc.) and the amount of additional capital that would be required to offset those expenses or risks. Second, managers can use their company’s profit margin information to estimate how much profit would be generated if those risks do not occur (e.g. higher profits if not producing a new product). Finally, managers can assess whether it is likely that these risks will occur (e.g. the probability of a product not selling well and not generating the anticipated profits).
Using these three steps, firms can estimate what potential effects any given risk may have on their company and then determine whether it has positive or negative impacts on their business. If even one of these steps is left out, the accuracy of predictions will be decreased substantially. Many successful companies are those that have been able to predict market changes and can take measures to reduce the risks from them.
There are many factors that determine a firm’s financial health including macroeconomic indicators (e.g. GDP growth), microeconomic insights (e.g. competition) and industry specific risks (e.g. natural disasters).
Firms must know what macroeconomic indicators can affect their business, which ones they have control over and the factors that may impact their firm’s performance. This includes knowing the key economic indicators in their industry and those of the companies they compete with. Also important is understanding how things such as inflation, interest rates, exchange rates, tax changes etc. will impact a company’s business since this information allows firms to make more accurate predictions about future performance relative to competitors.
To effectively manage financial risk a company should know what market forces are affecting its industry and thus allowing it to predict any potential negative implications of those trends on its own business.