The Fundamentals of Financial Risk and Financial Risk Management

Financial risk management is the process that involves the practice of identifying and managing potential finance-related risks to minimize their impact on the organization and its business operations. It mainly constitutes recognizing the risk, analyzing those risks, figuring out ways to outgrow consequences, making decisions & designing a strong strategy, and optimizing your business activities while implementing those strategies to reduce the impact of the threat. By adopting a proactive risk management strategy, you can not only save money and reduce financial risks but also manage your procurement processes efficiently. In this post, we will explore important details related to financial risks, as well as how to mitigate them by understanding their different types.

What is Financial Risk and Financial Risk Management?

Financial risk can be considered as an event when an organization stands a chance of encountering a loss or suffering other financial difficulties in one or many aspects. Financial risk management is an important aspect of directing and managing an efficient business. As risks are a part of the business industry, it completely depends on the ability of an organization based on how it navigates risk events and make effective decisions to minimize their consequences.

The best an organization can do is to have an effective financial risk management strategy and be prepared with a backup plan when adverse events arise. In general, financial risk management can be defined as the process of analyzing and governing possible financial risks to reduce a business’s exposure to risk and minimize its impact on the organization. Hence, finance risk management provides a management technique that enables organizations to have effective internal controls and recognize, measure, and manage potential risks.

Major Categories of Financial Risk

Every investment has a certain level of risks associated with it, but keeping a balance between potential risks and possible rewards is the key. Financial Risk Management techniques allow organizations to maintain that balance and make required decisions accordingly. Organizations must have a basic understanding of various types of financial risks that will help them to analyze better and prevent massive losses. Financial Risks are broadly classified into four categories that are as follows: -

1. Market Risk- Market risks involve all sorts of risks that are associated with considerable changes in the market in which the company operates. The possibility of financial losses arising from changes or fluctuations in the prices of assets is referred to as market risk. Usually, this kind of risk is brought about by alterations in the price of stock, bonds, commodities, or currencies. Sometimes, economic factors like interest rates or inflation are often responsible for such shifts while geopolitical events may also play a significant role. Market risk does not only affect businesses but also individuals and entire economies. However, there is always some level of market risk in all types of investments, and it cannot be eliminated. Thus, consistently determining the effectiveness of business operations and using resources wisely is the key to minimizing exposure to such risks.
2. Liquidity Risk- It is a type of risk that refers to the ability of an organization that how easily it can convert its assets into cash or maintain a short-term cash flow in situations when the company needs funds. Certain factors that can present a considerable liquidity risk include economic or seasonal downturns, market volatility, and over-dependence on long-term assets that are hard to sell quickly. Managing liquidity risks is important for a business success, as it allows you to have sufficient cash reserves and plan for unexpected financial requirements. In general, managing liquidity risks is essential for maintaining financial health and avoiding miserable situations, especially in volatile or unexpected market conditions.
3. Credit Risk- Credit risk can be defined as the potential loss that might happen due to failures in repaying a loan or meet financial contracts. It is important for organizations to manage their own agreements or credit obligations while ensuring an adequate amount of cash flow to pay their bills or clear debts on time. If an organization fails to handle its payable bills, it might end up losing suppliers, which will ultimately impact their business performance.
4. Operational Risk- Operational risk is the type of risk that comes up as a result of an organization's regular business operations. It constitutes data breaches, lawsuits, internal & external fraud, cyberattacks, personal issues, employee conduct. Moreover, operational risk can possess a potential risk of huge loss due to failure in compliance with set policies and regulations that negatively impact an organization's growth and marketing activities. In simple words, operational risks involve risks associated with the day-to-day business operations within an organization.

It has become extremely important for organizations to incorporate financial risk management strategies to prevent any major loss and potential financial risks and maintain the continuity of business operations. The processes or techniques involved in financial risk management enable your organization to minimize the possibility of losing money on business investments by identifying, assessing, and controlling them efficiently.

Financial risk management strategies of an organization reflect its potential to identify, analyze, and manage risks effectively so as to minimize loss while effectively managing other business activities. Nowadays, you need to have an effective and tailored financial risk management plan for your organization to enhance your business performance, mitigate risks, and establish a successful & stable business. Don't wait for a crisis to strike! Contact our expert professionals at Procurement Resource to get access to the key to elevate your business processes by utilizing our market intelligence, procurement analytics, cost modeling, category insights, effective risk assessment and management, and much more. We assure you that our industry specialists will cater to your business requirements and help your organization optimize its business operations and mitigate risks effectively.

Author

Ayushi Raj Prabhakar (Business Insights Analyst in procurement resource)