Financial Risks

It may sound surprising, but profitable businesses can and do go bust. This is often due to poor management of financial risks, which leads to the business running out of cash to pay its obligations. In this Insight article we look at the main financial risks faced by businesses and how these can be addressed through careful planning and monitoring. Effective management of financial risks enables businesses of all sizes to withstand unexpected financial shocks and to be more resilient and profitable.

Financial risks fall into five broad categories: market risk, liquidity risk, expenses risk, credit risk and legal risk. Let’s look at each of these in turn and assess how they can affect a business’s financial performance.

Market Risk

Market Risk involves a substantial change in the market in which a firm is active. This can happen surprisingly quickly in times of rapid change. Think of Kodak which failed to embrace digital photography or BlackBerry which was rapidly overtaken by the touch screen technology pioneered by Apple – both businesses failed as a result.

It’s easy to assume well-established businesses are immune to market changes, but the winners are those who watch the horizon for emerging trends and innovate to keep their offering relevant. With many businesses facing the risk of AI undermining their business models, market risk is more pertinent today than ever.
 

Liquidity Risk 

Liquidity Risk involves the management of daily cashflow and the ability to convert assets into cash if required. Here prompt invoicing and collection of monies owed is critical as well as access to short term bank finance which can be called on if needed.

It’s all too easy to be lured into complacency by a healthy-looking order book, but if invoices are not issued and monies collected promptly, a business can quickly run out of cash. The well-known accounting adage ‘Turnover is Vanity, Profit is Sanity, Cash is Reality’ is a good rule to follow to keep a business’s cashflow healthy.
 

Expenses Risk 

Expenses Risk is the prospect of facing unexpected bills or unplanned expenses. What would happen, for example, if a business was hit with huge costs following a fire or flood, or an adverse employment tribunal ruling? Here access to cash reserves, readily realisable assets, or additional bank finance could be a life saver.

Credit Risk 

Credit Risk refers to the exposure faced by businesses which advance credit to their customers, without managing the process carefully. Many businesses supply goods in advance of invoicing and professional firms commonly undertake work which is then invoiced in arrears. The crunch occurs when the expected revenues are not received on time.

Unfortunately, some customers routinely pay invoices late and others may be facing cashflow problems of their own. Businesses should run credit reports to assess the standing of their customers – and should stop providing services to any customer that fails to pay on time.  It is all too easy to assume a major client will pay eventually – but what happens if they do not?

Legal Risk 

Legal Risk is the danger of incurring large financial losses as the result of legal proceedings. A dispute with a customer can quickly run-up huge expenses if lawyers are involved and the costs of court proceedings can be crippling to even the most resilient of organisations. Passions can run high when there is a dispute, but businesses need to consider the commercial dangers of litigation, rather than letting a sense of injustice cloud judgement.

Managing Financial Risks

Managing financial risks is a necessary part of running a business, but careful planning can greatly reduce or eliminate the worst exposures.

First, identify all the financial risks that affect the business, these may include credit and employment risks, data security, key employees and supplier exposure and others.  Think carefully about the business model and whether this may be affected by emerging developments such as AI.

Second analyse and quantify each risk, some may be relatively minor issues which would inconvenience operations but not be business critical.  Then put in place measures to protect against the major risks.  This may include cashflow management, arranging standby credit with the bank or using invoice factoring.  Undertake regular financial reviews including credit analysis of customers and suppliers and build up financial reserves as much as possible.  Set KPIs for each measure, so the strategy can be easily monitored.

Financial risks can also be effectively mitigated using insurance, such as keyman cover, directors and officers (D&O) and professional indemnity insurance. Once the financial risk strategy is complete, don’t put it in a drawer and forget about it.  Regularly review the strategy and monitor KPIs to ensure the business is resilient in the face of an unexpected financial shock.

If you would like to discuss this topic further and understand the implications on your business, please don’t hesitate to contact the team.