Manage financial risks

Learn about the types of financial risks your business could face, and how to manage these risks and make the right decisions for your business.

There will always be risks involved with running a business. Risk in business comes in many forms, including:

  • financial
  • competitive (from your competition)
  • economic
  • reputational
  • natural disasters.

Financial risk management involves putting a plan in place to anticipate possible financial risks in the future and develop a clear pathway for avoiding cash loss.

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    Understand financial risk

    Financial risk is a potential future situation that causes your business to lose money. This situation could affect your cash flow and leave you unable to meet your obligations. If you borrow a large amount of money to start or run your business, you are more exposed to financial risk then businesses with smaller levels of debt.

    Financial risks affect every business, and they are impossible to avoid, but a good financial risk management plan will allow you to reduce the impact and potentially avoid a negative outcome. This will also allow you to optimise the level of risk you accept for maximising business opportunities, as risks can often also have positive outcomes.

    Types of risks

    Financial risk can include:

    • credit risk
    • liquidity and leverage risk
    • foreign investment risk
    • any risk related to your cash flow, such as customers not paying their invoices.

    Your business may face different financial risks depending on your structure. Your financial risk can also increase when the business cycle in your industry has a significant economic contraction, even if it's only seasonal or temporary.

    Market risk is based around uncertainty in changes to your market and is something you can't control. To manage market risk, predict how market trends may affect your cash flow.

    For example, a significant market trend for print newspaper businesses was the move from traditional print copies to online media. This trend continues to affect businesses today, and you may find that your customers prefer to shop online rather than in physical storefronts. This is a market risk to the profitability of your physical storefront.

    You can manage market risk by:

    • researching what your customers want and expect
    • identifying how this will impact your business
    • shifting your business strategy to suit a solution, such as creating a website and building a social media presence.

    Learn how to adapt and change your business to respond to market risks.

    You can apply this same type of risk mitigation strategy to any market risk:

    1. Research market trends and customer behaviours and forecast how your market will change based on this data.
    2. Identify your business's position within the changing market and assess where there might be financial risks.
    3. Develop or update your business plan and create strategies to allow your business to continue to run and grow, and meet the changing needs of your customers.
    4. Measure your financial performance and benchmark this against your forecasts to confirm that your financial risk management plan is effective.

    Competition risk is the risk that competing businesses pose to your business, and whether their activities will have a negative effect on your cash flow.

    This risk can present itself in 2 main ways:

    • New competitors—could be a new business, or an existing business expanding into your market. This may result in a downturn for your business or a loss of customers. You may need to reduce your prices to remain competitive, which then affects your profit margin.
    • Existing competitors—are those you already know of who may adapt their product offering to specifically target your sales, revenue and customers. They may choose to reduce their prices on a product that compares to your own or beat you to launch a new product offer.

    Learn how to adapt and change your business to respond to competition risks.

    To help manage and avoid competitive risk:

    • start researching your competition when you begin developing your products so you can differentiate yourself and define your unique selling point within the market
    • continue researching your competition and market, so you can respond to risks as soon as they appear
    • understand how you provide value to your customers and reinforce any points of difference
    • build your relationships with existing customers to create loyalty, community and trust around your brand and products—this will make them less likely to be tempted by the competition
    • work to constantly improve your product offerings so there is less opportunity for your competition to develop something better
    • use trademarks, copyrights and patents to protect your intellectual property.

    Liquidity risk is focused on your cash flow management, and whether you'll have enough cash to cover your payments and debts as they are due. To manage this risk, make sure you have cash flowing into your business before it needs to flow out again. This means you're paying bills and receiving your revenue before your invoices are due.

    This could threaten any type of business due to lack of buyers or sales. If you run a seasonal business (where you make the majority of your profit in a seasonal window), you may face a higher rate of liquidity risk. You'll need to plan how you'll manage this risk to ensure you have cash for the whole year to meet ongoing costs and expenditure.

    If you can't pay your debts or meet your financial obligations, your business may face insolvency and, depending on your structure, you may become personally responsible for covering the costs.

    To manage liquidity risk:

    • develop a system that allows you to monitor and manage your cash flow on a daily, weekly and monthly basis. Make sure you have full access to all of your financial transactions and invoicing, and know what amounts are due, even if you have an accountant or advisor managing this for you
    • forecast likely situations that may affect your cash flow and develop a plan for how you'll continue to meet your obligations
    • stay on top of your payments, debts and invoicing to be able to accurately manage your finances and plan for the future.

    Leverage risk looks at your level of business debt (borrowings). A more highly leveraged business will have:

    • a lower owner equity level
    • higher interest payments
    • ongoing repayment obligations.

    Leverage risk is more common during a downturn in your business cycle when you have a sharp decline in sales. Your cash flow and liquidity will be affected by reduced sales revenue and your interest and loan repayments will take up a higher proportion of your total revenue.

    You can help mitigate leverage risk by:

    • understanding the drivers of your business cycle such as supply and demand
    • maintaining manageable levels of debt
    • reviewing return on investment ratios regularly to ensure your investments are providing adequate returns.

    Read more about getting paid and paying others.

    Credit risk can impact your business in 2 ways:

    • the risk of borrowing money and not being able to meet your repayments (more commonly a liquidity risk)
    • balancing the risk of extending credit to your own customers (debtors) against the probability of them defaulting on their payments.

    Your cash flow will be negatively affected if your customers don't pay invoices for goods or services that have been delivered on credit. It may involve other costly and time-consuming processes such as debt recovery, negotiation or writing off unpaid invoices.

    You can manage credit risk by:

    • running thorough credit checks before extending credit to a new client or customer
    • developing an application process for customers who wish to purchase your goods or services on credit
    • having a contract in place with your customers with clear terms and conditions
    • applying credit limits to all accounts and customers to limit the risk to your cash flow. Credit limits will vary across business types, industries and sizes
    • staying on top of customer payments to see which customers pay on time, and who develops a pattern of late payments. Have a process in place for revoking credit to customers who are unreliable with payment deadlines
    • analysing and managing your accounts receivable days and keeping them at or below the 30-to-40-day average
    • establishing close relationships with all customers so you can maintain good communication and have visibility on their current financial situation.

    Growing your business brings new risks, as revenue from sales of your products or services is received after you have to pay for the assets or resources needed to expand your operations.

    As your business grows, you must pay for your inventory, increased staff numbers and advertising before you notice an increase in your sales figures. This may affect your cash flow and your ability to meet your financial obligations such as wages and loan repayments.

    You can manage growth risk by having a carefully planned budget and cash flow structure.

    Develop a financial risk management strategy

    Financial risk management is a strategy that allows you to understand and plan for financial risks that may affect your business. You can't completely remove risk, but you can research and plan for potential situations your business might face and use this information to decide which risks you're willing to take, which can be mitigated and which you'd prefer to avoid.

    Risks can often lead to good outcomes and new opportunities (higher risk can lead to higher reward) so there may be some risks you're willing to take. Have a plan in place to anticipate possible risks and their outcomes so you can work with a level of risk you're comfortable with. This is known as your risk appetite.

    Your financial risk management strategy must include a clear plan for action. This should include your present policies and procedures that you use to manage financial risk, as well as a plan for how to respond to potential future risks, allowing you to minimise any negative impact.

    Follow these key steps to develop a financial risk management process.

    Firstly, identify your risk exposure. You should:

    1. Map out the financial risks that apply to your business (make a list using the balance sheet of your business as a reference).
    2. Identify the triggers and causes of each risk.
    3. Forecast how likely each risk is to occur.
    4. Forecast how each scenario is likely to affect your business, starting with those that are most likely to occur. Put a financial value on each risk as part of this step.
    5. Create a plan of action for mitigating each risk, as well as how you plan to respond to it if your mitigation efforts fail.

    Consider things such as your main sources of revenue, the liquidity of your debtors, your current costs and expenditure, and market trends.

    Example

    Gary's mechanical business has serviced 10 cars in a month. All owners have taken $1,000 in credit each for services to their cars. Gary is due to pay his suppliers $5,000 by the end of the month. If he doesn't receive payment for at least half of the credit he may find he is unable to pay the suppliers on time. This is a high risk to Gary's business.

    Develop an overall risk management plan for your business to ensure you fully understand the impact of risks to your business.

    Key steps include:

    • identifying the risk or issue
    • determining the likelihood of the risk or issue occurring.

    Divide your identified issues into reputational risks, operational risks and financial risks to help clarify where you should start.

    Think about what you need to do to reduce the likelihood of the risk occurring and the impact (consequences) of the risk:

    • What action you must take to mitigate the risk?
    • What resources (e.g. cash, people) are needed to take action?
    • Who has responsibility for taking action?
    • When is the target date for resolving the risk or issue?

    After taking action to reduce a risk's likelihood or impact, review your plan to determine if the action was successful.

    Once you have identified the most probable financial risks and forecasted their likely impact, you need to decide how you'll take action. Make sure your actions are aligned with the goals and objectives of your business, as well as your mission and values. You may decide to completely avoid certain risks or manage the impact of others. Benchmarking these against your goals will provide you with a useful reference point and may help with future planning.

    There may be some risks that you can't avoid or reduce, which is when you should consider taking out insurance.

    Example

    Gary has assessed the level of risk posed by the large monthly credit figure. He decides the risk is too great for his business, but he knows that it's normal in his line of business to offer credit. Gary decides to change his credit policy to mitigate the risk by offering a smaller maximum credit limit, and he encourages customers to pay in full upfront by offering them a discount.

    Many businesses take out insurance to help protect themselves against financial risk. Carefully consider what types of insurance you buy, and what risks it covers, as it will be an additional cost to include on your balance sheet. You may not need insurance for risks that will likely only have a minor impact on your operations.

    Common types of business insurance include:

    • building and contents—to protect your assets, loss of profit due to business interruption and unforeseen events
    • liability—which covers legal expenses of third party death, injury, or property damage
    • workers' compensation—if an employee lodges a claim (or personal accident and illness if you're self-employed)
    • professional indemnity—if your business is giving advice, to avoid the risk of lawsuits.

    Use risk and return ratios to help judge how successful your business investments are. Find out how further investment, such as a cash injection to increase or improve your assets, may affect specific areas of your business.

    Return on assets ratio

    The return on assets ratio (sometimes known as return on investment ratio) measures the return on the funds you invest in your business as the business owner. It includes all productive assets. This helps you assess how successful your investment has been in return for the risk of running your business and will guide decisions about investing more in the profitable areas of your business.

    This ratio shows how effectively your business can generate profit. The higher the ratio, the greater the return on your investment in your business.

    If your return on assets ratio is less than the rate of return on an alternative risk-free investment, such as a bank savings account or other secure bank investments, you may need to work with an accountant or financial adviser to consider other investment options.

    Use our interactive calculator to help you work out your return on assets ratio.

    Calculate return on assets

    $$\text{Return on assets} = \frac{\text{Net profit}}{\text{Total assets}} \times 100$$

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