Risk is inherent in any business enterprise, and good risk management is an essential aspect of running a successful business. A company's management has varying levels of control in regard to risk. Some risks can be directly managed; other risks are largely beyond the control of company management. Sometimes, the best a company can do is try to anticipate possible risks, assess the potential impact on the company's business, and be prepared with a plan to react to adverse events.
There are many ways to categorize a company's financial risks. One approach for thisis provided by separating financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.
Key Takeaways
- There are four broad categories of financial risk that most companies must contend with.
- Market risk is what happens when there is a substantial change in the particular marketplace in which a company competes.
- Credit risk is when companies give their customers a line of credit; also, a company's risk of not having enough funds to pay its bills.
- Liquidity risk refers to how easily a company can convert its assets into cash if it needs funds; it also refers to its daily cash flow.
- Operational risks emerge as a result of a company's regular business activities and include fraud, lawsuits, and personnel issues.
1. Market Risk
Market riskinvolves the risk of changing conditions in the specific marketplace in which a company competes for business. One example of market risk is the increasing tendency of consumers to shop online. This aspect of market risk has presented significant challenges to traditional retail businesses.
Companies that have been able to make the necessary adaptations to serve an online shopping public have thrived and seen substantial revenue growth, while companies that have been slow to adapt or made bad choices in their reaction to the changing marketplace have fallen by the wayside. Another trend is the ESG trend. Companies are now called to move from polluting industries to cleaner ones, from seeking profits mostly to seeking profits while doing good in communities. Companies who lag behind will be poor in capital, short in talent, and low in branding.
This example also relates to another element of market risk—the risk of being outmaneuvered by competitors. In an increasingly competitive global marketplace, often with narrowing profit margins, the most financially successful companies are most successful in offering a unique value proposition that makes them stand out from the crowd and gives them a solid marketplace identity.
2. Credit Risk
Credit risk is the risk businesses incur by extending credit to customers. It can also refer to the company's own credit risk with suppliers. A business takes a financial risk when it provides financing of purchases to its customers, due to the possibility that a customer may default on payment.
A company must handle its own credit obligations by ensuring that it always has sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise, suppliers may either stop extending credit to the company or even stop doing business with the company altogether.
While managing risk is an important part of effectively running a business, a company's management can only have so much control. In some cases, the best thing management can do is to anticipate potential risks and be prepared.
3. Liquidity Risk
Liquidity risk includes asset liquidity and operational funding liquidity risk. Asset liquidity refers to the relative ease with which a company can convert its assets into cash should there be a sudden, substantial need for additional cash flow. Operational funding liquidity is a reference to daily cash flow.
General or seasonal downturns in revenue can present a substantial risk if the company suddenly finds itself without enough cash on hand to pay the basic expenses necessary to continue functioning as a business. This is why cash flow management is critical to business success—and why analysts and investors look at metrics such as free cash flow when evaluating companies as an equity investment.
4. Operational Risk
Operational risks refer to the various risks that can arise from a company's ordinary business activities. The operational risk category includes lawsuits, fraud risk, personnel problems, and business model risk, which is the risk that a company's models of marketing and growth plans may prove to be inaccurate or inadequate.
As an enthusiast in the field of risk management and finance, let's delve into the concepts detailed in the article you provided.
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Market Risk: This involves the potential impact of changing conditions within a specific market where a company operates. Market risks encompass shifts in consumer behavior, technological advancements, regulatory changes, or emerging trends like the ESG (Environmental, Social, and Governance) movement. The example of traditional retail businesses struggling due to the rise of online shopping showcases how companies that adapt and innovate thrive while those slow to react falter. Moreover, it highlights the risk of being outmaneuvered by competitors in a highly competitive landscape.
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Credit Risk: This is the risk associated with extending credit to customers or dealing with the company's own credit obligations with suppliers. Offering credit to customers introduces the possibility of defaults, impacting the company's financial health. Managing credit risk involves ensuring sufficient cash flow to meet accounts payable, as failure to do so might lead to suppliers withdrawing credit or discontinuing business relationships.
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Liquidity Risk: Liquidity risk encompasses both asset liquidity and operational funding liquidity. Asset liquidity refers to a company's ability to convert assets into cash swiftly, especially during urgent cash flow needs. Operational funding liquidity, on the other hand, pertains to daily cash flow requirements. Managing liquidity risks is crucial, particularly during revenue downturns, as insufficient cash flow could jeopardize a company's ability to meet essential expenses.
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Operational Risk: These risks stem from a company's routine operations and include various factors such as legal liabilities (lawsuits), fraud, personnel issues, and risks associated with business models. Business model risk, specifically, pertains to the possibility of marketing strategies or growth plans proving inadequate or inaccurate.
In essence, effective risk management involves identifying, assessing, and mitigating these four broad categories of financial risk. Companies that excel in managing these risks tend to adapt swiftly to market changes, maintain healthy credit practices, manage liquidity effectively, and mitigate various operational risks associated with their business activities.
