Financial Risk Management Strategies for protecting your business

Have you ever heard of financial risk management strategies? They’re basically plans that help individuals deal with different kinds of financial risks.

Managing risks is crucial in finance and has become more critical for everyone involved in the financial services industry over time.

The 2008 Global Financial Crisis exposed several vulnerabilities in our risk management systems, prompting governments, financial firms, and participants in the financial system to re-examine the way they view, evaluate, and handle risk.

As new technologies and securities like artificial intelligence, machine learning, and cryptocurrencies emerge, the need to manage risk becomes even more critical, and risk management practices must continue to evolve and become more sophisticated.

So if you’re looking to protect your finances and investments, these strategies are definitely going to help you. In this blog, we’ll be diving deeper into the topic and exploring some effective strategies you can use. 

Understanding Financial Risks-

To understand financial risk management, it’s essential to first know the types of financial risks faced by individuals, corporations, and financial institutions. Financial risks are events or situations that have undesirable or unpredictable financial impacts.

Individuals face various financial risks, including:

1. Risk of losing income due to unemployment, underemployment, health problems, disability, or premature death.
2. Risk of higher or unexpected expenses, like facing emergency expenses or exceeding the budget.
3. Risk related to assets or investments, including potential loss in their value or damage and theft.
4. Risks related to debt or credit financing, like being unable to pay off credit card debt, asset loans, or mortgages.

Corporations and financial institutions face additional types of financial risks, such as:

Market risk, where financial assets can suffer losses due to the dynamics of the overall financial markets.

1. Credit Risk, where a counterparty may fail to meet contractual obligations, such as an individual defaulting on their personal loan.
2. Liquidity Risk, where there might be cash constraints that can prevent funding obligations from being met, such as a bank not having enough cash to meet deposit withdrawal demand.
3. Operational Risk, where losses can occur due to failed internal processes, people, and systems. For instance, an employee making a mistake on a transaction that results in monetary loss.

Risk and Return in Financial Management

In financial management, investing involves risk and return. You cannot have one without the other. Generally, to achieve higher investment returns, a businessman needs to take on more investment risk. If not, they should expect returns that are only above the risk-free rate of return.

Return is the percentage gained from the original investment over a given time. Financial management commonly uses two rates of return: nominal and real rates of return. Nominal rates include inflation, while real rates exclude it.

Investment returns can come in the form of capital gains, interest, dividends, or rental income from real estate. Nominal investment returns can be calculated using three variables: initial investment, ending value of investment, and investment time period.

For example, if an initial investment of $100 grows to $120 in one year, the nominal rate of return is calculated by dividing the ending value of the investment by the initial investment and subtracting 1. In this case, the nominal rate of return is 20%.

To calculate the real rate of return, we subtract the inflation rate from the nominal rate of return. If the inflation rate is 3%, then the real rate of return is 17%. Real rates of return are better for reflecting the purchasing power of investment returns.

The Risk-Return Relationship 

Investment returns can be higher if you take on higher investment risks, but not always. Diversifying your investment portfolio can help generate a comparable return with less risk than an undiversified one. However, diversification has its limits as a portfolio grows.

The risk-return trade-off is a fundamental principle of investing. There are many types of investments, including money market securities, bonds, public equities, private equity, private debt, and real estate, each with varying levels of risk. Different investments with different risk-return profiles cater to the risk appetites of various investors.

Consider the graph above. 

Asset class #1, risk-free bonds, is considered the safest asset since governments can print money to pay off debts. However, it has the lowest investment return. As we move up the risk-return spectrum, each asset class gets riskier but also offers higher potential investment returns.

Asset class #5 is private equity, where investors invest in private companies that are not publicly traded. Although private equity investments are riskier than public equities and have additional risks like liquidity risk, they offer investors the highest potential investment returns.

Financial Risk Management Strategies

If you want to manage financial risks, there’s a four-stage process you can follow. 

1. Identify potential financial risks
2. Analyze and quantify the severity of these risks
3. Decide on a strategy to manage these risks
4. Monitor the success of the strategy

Individuals and corporations can both use various risk management strategies. For individuals, some strategies include:

1. Avoiding risk by eliminating activities that can expose them to risk
2. Reducing risk by mitigating potential losses or the severity of potential losses
3. Transferring risk by offloading it to a third party
4. Retaining risk by accepting responsibility for a particular risk

At the corporate level, the same strategies may be used, but in slightly different contexts. For example:

1. Avoiding risk by eliminating activities that can expose the corporation to risk
2. Reducing risk by mitigating potential losses or the severity of potential losses
3. Transferring risk by offloading it to a third party
4. Retaining risk by accepting responsibility for a particular risk

It can be difficult to decide which strategy to use for a particular risk. The nature of the risk and the individual’s or corporation’s current risk appetite should be considered. Risks should be fully understood before deciding on the appropriate strategy to manage them.

For example, many individuals with spouses and children purchase life insurance to protect against the risk of premature death. They want to insure against the loss of income and ensure there is an income safety net for surviving family members.

In the lumber industry, many producers choose to retain their risk of exposure to lumber prices rather than hedging it with futures contracts. If they were to hedge their risk, they could place themselves at a disadvantage if the commodity price begins to move in a favorable direction.

Conclusion 

In conclusion, financial risk management is a crucial step in protecting your assets, whether personal or related to a company. To implement an effective risk management plan, you should first identify the risks and measure them. Learning about investments, turning to insurance policies, building an emergency fund, and diversifying your income sources are also important steps to consider. 

Additionally, it is crucial to reassess your risks frequently and do your due diligence before making any financial decisions. By following these tips, you can create a solid financial risk management plan that can protect your assets and help you achieve your financial goals

Editor’s Choice:

Entrepreneurship: Funding, Marketing, And Growth Strategies

Impact of Technology on Finance Management