Financial Risk Management Fundamentals

Financial risk management is a function of enterprise risk management (ERM) that has to do with handling, identifying, and treating financial risks. Financial risk management is an especially sensitive and critical aspect of risk management for many companies, as it has to do with the safeguarding of the organization’s finances and the prevention of loss. Healthy cash flow, diversification, and competent financial management all play a hand in an effective financial risk management strategy. Good financial risk management leads to cost savings, better decision-making, and improved returns.

By understanding their financial risk landscape and taking a proactive approach to financial risk management (FRM), companies can stay ahead of potential threats to their bottom line and make informed, insightful investments and decisions. FRM best practices offer companies ways to handle the most common financial risks, and reduce or eliminate the likelihood or impact of those risks. With a financial risk management approach and regular risk assessments, your organization can manage various types of risks, and gain an advantage in a market full of volatility.

What are Six Types of Financial Risks?

To understand financial risk management, it’s important to understand the different types of financial risks that face companies. Financial risk is the likelihood that the organization will lose money on a business investment or other decision, including loss of capital. Below are six types of risks that fall into the financial sphere, including operational risk, credit risk, market risk, liquidity risk, legal risk, and foreign exchange risk. By studying these risk types and implementing best practices when it comes to financial instruments, portfolio management, budgeting and allocation, and asset management, your organization can benefit from better financial decision-making.

Operational Risk

Operational risk in the context of financial risk management encompasses any unforeseen events in day-to-day operations that could have an effect on the company’s bottom line. For example, having a manufacturing plant or data center go out for several hours could end up in a loss of revenue for the business. These types of risks are realized when systems, processes, people, or external events interfere with daily functions. It’s difficult to completely eliminate operational risk — since as long as there are processes, people, and systems, there will be errors. However, by putting mitigation strategies in place to limit operational risk to an acceptable risk tolerance threshold, companies can continue to thrive in spite of any residual risk. Financial risk management (FRM) and operational risk management (ORM) teams can collaborate to tackle and manage potential risks for increased effectiveness.

Credit Risk

Credit risk is the risk that a customer or borrower fails to meet their financial obligations, like payments. Companies can take steps to mitigate credit risk through insurance and collateral, however, some parties may default regardless. Organizations should understand and benchmark any historical instances of credit defaults, analyze trends, and act accordingly to manage future credit risks, like through flagging high-risk transactions or preventing buyers with poor credit from taking out loans. Credit checks are another common means used to evaluate a customer or borrower’s eligibility for deferred payments.

Market Risk

Market risks have to do with capital markets and financial markets as a whole, such as a risk in a particular sector or geopolitical effects on macroeconomic conditions. High interest rates in the market discourage people from taking out loans and encourage savings, providing a potential risk to lenders and banks’ revenue. The availability of capital can impact companies’ valuations. Market risks are difficult to predict and may come about suddenly, but maintaining a strong FRM program can keep your organization vigilant and prepared.

Liquidity Risk

Liquidity risk is somewhat like the inverse of credit risk, in which the organization is unable to meet its financial obligations or make payments — due to a lack of cash or funds. Liquidity risk can be an existential threat to an organization, and even lead to a going-concern risk. Managing cash flow, liabilities, and assets in a balanced way and maintaining regular FRM practices and controls can help organizations limit the risk of liquidity and keep the company’s cash flow healthy. 

Legal Risks

Legal or compliance risks are those risks associated with a loss due to failing to meet legal, regulatory, or compliance requirements that are necessary for your organization and your industry. Legal risks can include the risk of financial loss due to lawsuits, like with a defective product causing bodily injury, while the risk of noncompliance can lead to fines and lost sales. Integrating FRM with the organization’s larger enterprise risk management (or equivalent) function ensures that risks don’t fall through the cracks between silos and encourages a collaborative and proactive approach to risk management.

Foreign Exchange Risk or Currency Risk

Foreign exchange or currency risks are realized when unexpected changes to the foreign currency exchange rate have an impact on the organization’s financial standing. Fluctuations in foreign exchange rates can have a substantial impact on the valuation of an organization’s investments, financial positions, and holdings, especially when they’re sudden and unforeseen.  This type of risk is more likely to occur in multinational corporations; companies that are heavily invested in imports and exports; and organizations that have significant financial holdings in foreign countries. Managing this economic exposure can be achieved through operational strategies, like diversifying the locations of facilities; markets where products are sold; and sourcing of materials. Currency risk-specific mitigation options are also available, such as currency flows and currency swaps that allow companies to limit the impact of currency exchange rate changes.

What Are the Components of a Financial Risk Assessment Plan?

Financial risk assessments follow the same methodology as other risk assessment approaches, with a cycle of risk identification, risk analysis, risk treatment, and risk monitoring, though with a focus on financial risks. 

However, before conducting a financial risk assessment, companies and their senior leadership should establish clearly defined risk tolerance thresholds. These thresholds indicate how much risk the organization is willing to take on, and should be used to guide decision-making.

Risk Identification

Risk identification is always the first step in any risk assessment process, and this applies to financial risk assessments as well. In addition to learning from past experiences, published standards, and best practices, organizations should consider a few other methods of identifying financial risks. A good starting point for identifying risks is to examine the company’s financial statements, disclosures, balance sheet, and other key reports and documentation, and noting any observations. Assessors should pay particular attention to debt, expenses, and liabilities, as well as cash flow. Financial operational risks should emerge too, with all identified risks recorded in a risk register. Risk management software can help internal teams manage their centralized risk register and collaborate with teammates to complete treatment efforts.

Risk Analysis

The risk analysis (sometimes known as the risk assessment) step follows the risk identification phase and requires assessors to evaluate the likelihood that a risk could be realized, and the significance of the impact should the risk be realized. By combining the likelihood score of the risk and impact score of the risk, the risk can be prioritized and categorized for treatment. Although risk analyses and scoring should have some bearing on the prioritization of remediation efforts, the company should also consider business objectives, goals, and priorities when deciding which risks to treat before others.

As companies review risk scores and risk analyses, they should begin to investigate methods for treating identified risks.

Risk Treatment

Even as risks are being identified and analyzed, assessors are considering potential treatments for those risks. The risk treatment phase of a risk assessment involves studying each identified risk and devising a treatment plan that addresses each item. There are four common risk treatments: risk acceptance, risk avoidance, risk transference, and risk mitigation. 

Risk acceptance involves knowingly accepting the risks associated with a decision. Risk avoidance involves choosing not to make the decision that leads to the potential risk. Risk transference occurs when some or more of the risk exposure is transferred to a third party, a service provider, or insurance. Risk mitigation requires the implementation of processes and solutions that limit either the likelihood that a risk will occur, or the impact should that risk be realized. Ideally, a mitigation plan would reduce the risk score of that risk to a tolerable level for the company.

Each risk, regardless of treatment method, requires some kind of action plan — even if that action plan is “Continue and accept the risk.” The action plans for some risks will be more complex than others, and some may need to become projects in their own right. Establishing new controls and processes is often a lengthy undertaking that needs to incorporate employee training and cross-functional collaboration.

But, by applying the best possible risk treatments to financial risks, your organization can protect its revenue, reduce costs, and provide value for stakeholders.

Risk Monitoring

Risk monitoring is the final component in a sound financial risk assessment strategy and approach. Monitoring financial risks is continuous, and involves periodically checking in on the progress of risk mitigation initiatives, updating the risk register, and using lessons learned to enhance the organization’s financial risk management process. Financial risk assessments should be scheduled at least annually, and the organization should convene key stakeholders quarterly, or more often, to discuss and manage financial risks. These periodic risk assessments can serve as benchmarks for the company, demonstrating progress year-over-year.

By applying the tenets of risk management to financial risks, businesses can get a better handle on their risk posture and prepare for various types of financial pitfalls that could threaten the bottom line. 

Benefits of Financial Risk Management

Applying a risk management methodology to financial risks yields many benefits for companies that are able to implement FRM well. Financial risk management enables companies and teams to take a cross-functional approach to finances and financial risk, drawing from expertise across the organization to face risk treatment and mitigation challenges. By going through a continuous and regular lifecycle of identifying risks, analyzing them, treating them, and monitoring them, the company will benefit from the optimization of financial risk management processes, and continue to reduce the likelihood and impact of identified risks. Furthermore, with a good FRM program, and data protection safeguards in place, businesses can have more confidence in their financial statements and reporting.

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Risk management brings different stakeholders from across the company together to come up with innovative solutions for mitigating risks and combating threats. But, with so many risks to keep track of and resources being pulled in different directions, running an effective enterprise risk management function seems unlikely, if not impossible. Managing resources and stakeholders alone would be an undertaking.

Purpose-built risk management software can help you and your team cut through the overhead, collaborate in a central workspace, and manage risks and controls via informative dashboards. Keeping up with version control and monitoring remediation progress all becomes much quicker and easier when you have the right technology in place. Schedule your tailored demo of AuditBoard’s RiskOversight solution today!