More than 80 percent of business failures can be traced back to poor cash flow management. That statistic proves the importance of knowing how money moves through a business.
This movement of money creates financial risks. Almost anyone can benefit from learning about the different types of risk and how to manage them. After all, running your household may be a bit like running a business when it comes to finances.
Let’s take a look at the types of risks and how to use them to your advantage.
Many Financial Risks Are Debt-Related
We’ll start with the most obvious kind of financial risk: debt.
A debt creates a financial risk, because it creates an obligation. If you take out a loan and can’t pay it back, you risk some negative consequences. You’ll default on the loan and your credit will be damaged.
You may find your assets seized, or you may need to declare bankruptcy. If you’re running a business, you may have to shut down operations.
As most business owners know, though, debt is sometimes necessary. You may need to take out a loan to finance payroll so you can hire more people to serve your customers. An individual may take out a loan so they can buy a car and commute to their job.
Without the loan, both the business owner and the worker are in trouble. The business owner’s staff may not be able to keep up with customer demands, leading to lost sales. The worker might get fired from their job if they’re late or miss shifts.
Working with Debt
The key is to manage this kind of risk wisely. Instead of taking a loan for the full cost of a new car, you might pay part of the bill with your savings. You might also consider looking for a more affordable used car versus a brand new one.
You may be able to pay debts down faster. Getting a lower interest rate can also help. Finally, look at the affordability of debt, and weigh the costs against the risks of not taking it on.
Late Payments and Nonpayment Are Credit Risks
Related to debt is a type of financial risk known as a credit risk. Debts are sometimes called credit risks. Credit risk means there’s a chance someone won’t fulfill the terms of a contract.
When you miss a payment on your loan, you’re not fulfilling the terms of your contract. When someone pays you late or not at all, they’re not fulfilling the terms of their contract with you.
It should be clear why credit risks like late payments and nonpaying customers are problems for business owners. If you expect to get paid for an invoice and the money doesn’t arrive, how does that affect your cash flow?
You may find yourself taking on more debt, using savings, or issuing IOUs to vendors.
It’s especially important for freelancers to manage credit risks properly. Set up policies that incentivize early payment and punish late payment. Always vet your customers beforehand too.
If you can, ask for a down payment or partial payment. If a customer does pay late, offer to help by structuring a payment plan.
Individuals can run into issues with their own employers. A company in financial trouble may ask employees to keep working, even as they fall behind on payroll. Managing this sort of risk is more difficult, but can still be done.
Liquidity Risks Look at Your Assets
Next up on our list of risk in finance is the liquidity risk. This type of risk is associated with the type of assets you have.
It applies to businesses and individuals equally. You want to look at how you can turn any of your assets into cash.
Cash is the most liquid of all assets. Any money sitting in your bank account can be used to buy something or pay down debt right now. Savings that are locked up in stocks or bonds are less liquid, because they have to be sold and turned into cash first.
Other assets are even less liquid. A house, for example, is not a liquid asset. It may take you months to sell your property.
If all your assets are real estate, you may have a large net worth. You may not be able to access those funds easily.
Liquid assets are good to have because they can help you in a pinch. Still, it’s a good idea to invest in non-liquid assets as well. A piece of property can value, adding more to your estate or business.
The key here is to strike a balance. Financial risk management will build a good ratio of liquid to non-liquid assets. The right liquidity allows you to make financial moves quickly when you need to.
The Operational Risk
Of all the types of risks in finance, the operational risk is perhaps the least understood. So, what is a financial risk when it comes to operations?
Operational risks are the cost of doing business. Like taking out a loan, they may be necessary to keep the business running.
An example would be paying your electricity bill. If the electricity company cuts off your power, you’re not going to do much business.
Operational risks abound in business. You may encounter fraud or theft, which costs the business money. Poor planning or making the wrong investments also present risks.
Individuals can apply the same logic to their households. If you need to pay rent or lose your home, that’s an operational cost and thus a risk. If you give your children too much in allowance and can’t pay a bill, that’s an operational risk.
Becoming more aware of financial risk and how to manage it the right way is an excellent skill for anyone to have. If you want to know more, you can start learning how to be a financial risk manager. Take a look at FRM level 1 and enhance your understanding.
Use Risk to Your Advantage
When you manage financial risks the right way, you can grow your business or start saving.
If you want to see what poor financial risk management does, we have plenty of examples. Take a look at some infamous cases where celebrities took risks and lost big time.
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