An entity's financial risk is correlated to how much debt they have. The greater the debt owed, the higher its financial risk.
Given the natural volatility of investment risk and fluctuations in financial markets, a company that poses a higher level of risk is therefore less likely to attract potential investors especially those who are risk-averse.
Types of financial risk
Both private and public entities can be susceptible to various types of financial risk, with varying levels of volatility depending on which types of investments are involved. This is a non-exhaustive list, covering some of the most common types of financial risk and their risk factors.
Credit risk is the possibility that a credit borrower cannot pay back their loans as obligated in the contract they signed with the lender. An entity's credit score measures their likelihood of paying debts back on time.
Asset liquidity refers to how easily an entity can convert their assets into cash. Liquidity risk is determined by an entity's ability to repay its debts without incurring severe losses, in worst cases resulting in bankruptcy. This risk occurs when the individual, company, or institution has to sell their assets at a lower value than they acquired it for.
Market risk is the likelihood that an entity will incur financial losses due to pricing fluctuations and volatility in the financial market. Depending on the investments made and assets held, this can affect interest rate risk, currency risk with foreign exchange rates, and stock market valuation.
This is the risk of financial losses due to underperformance or failure of internal business processes and operations, and potential external factors. Mismanagement of a company's functions, finances, and/or its employees can all result in high operational risk.
How to manage financial risk?
Financial institutions use credit scores to measure an individual's or company's credit risk and those with greater risk are likely to be penalized with higher interest rates when borrowing. Conversely, entities with lower financial risk can be incentivized with lower interest rates. Loan requests are also more likely to be rejected when the borrower has high credit risk.
In the case of investment in companies, investors will look at several metrics in a company, including its cash flow, net profit, recurring revenue, margins, etc. They take all these elements into consideration and calculate the overall risk of investing in the business.
Key benefits of financial risk management
Internal financial risk management within companies is equally crucial. Finance risk managers ensure diversification in investment portfolios to lower risk factors.
However, effective financial risk management covers much more than just investments–and should often be highly proactive rather than reactive.
By using a comprehensive spend management solution like Spendesk, companies and their finance teams can avoid financial loss and improve cash flow management all at once.
Benefits for finance teams & employees
Here's how a spend management tool can help your company mitigate financial risk:
With real time fund monitoring, companies know exactly how much they're spending, at any time. Having a 24/7 overview of company spending behaviours enables finance teams to budget smarter, facilitating business growth with lower credit risk and bankruptcy risk.
Finance teams can equip employees with prepaid physical or virtual payment cards with spending limits in order to prevent overspending when it comes to business and travel expenses.
Another key to monitoring funds is managing company subscriptions more effectively. Through proactively checking for and removing inactive subscriptions, companies can avoid wasting budget on tools that are no longer of value to their teams.
On a spend management platform, you can see exactly who makes every payment, and where the money went. This mitigates operational risks like credit card fraud and expense report fraud, where employees claim more reimbursements than they are owed.
Spotting and reacting to fraudulent purchase behaviour is also much easier when you can quickly freeze and control company cards from one digital platform.
An important strategy in successful financial risk management is keeping clear records of all company spending. Given how much information, documentation, and communication are involved in a company's accounting, an all-in-one spend management solution is truly a game changer.
If there are financial issues that arise within the company, spend management ensures that you have an "audit trail" to show what really happened instead of the expected financial scenario. Increased transparency helps finance teams and managers resolve disputes and audits quicker by identifying inconsistencies more accurately in quantitative data.
Another benefit: financial transparency means more trust between managers and employees. It gives managers more control and oversight on company spending, and it empowers employees to have more independence in making the best purchasing decisions for company expenses.