Risk analysis refers to the systematic study of risks and uncertainty that business encounter. Risk analysis objective is to identify the risks that a particular institution is likely to face. After identification of a risk, the risks managers work on understanding when and how the risk will likely arise. Risk managers are responsible for estimating the possible adverse outcomes caused by a risk. Risk managers are equally responsible for analyzing the risks followed by prevention or mitigation measures to reduce or control the extent of damage posed by the risk to a company. Institutions such as banks and investment management firms are in business always taking risks. The institutions can operate without closure because of the clearly established risk analysis and management departments. A primary role of risk analysis manager in an organization is to quantify financial risks involved in a trade, investments, and other business activities. The manager allocates a risk budget to all these activities in an organization (Bodnar, Hayt, & Marston 1998). The central bank demands that banks must identify their risks and ensure that they have enough capital to prevent insolvency even in the worst outcomes. The paper examines some financial risk sources and the strategic measures taken by financial institutions in managing financial risks.
Financial risk is the possible loss that a company's shareholders may incur when that company is in debt, or the amount of cash flow available is inadequate to meet its financial obligation. Financial risk is a situation that a company defaults its bonds forcing the bondholders to cash in their bonds. When a company is in crisis, the company uses debt money to pay its creditors first before the shareholders. Financial risk is a common term used when referring to risks in the finance industry. The risks include financial transactions such as an institution’s loan and its exposure to loan default. The term also used to refer to an uncertainty of shareholders collecting their returns because of the company’s monetary loss. However, investors can use some established financial risk ratios in assessing the company's amount of debt. For instance, the capital to debt ratio determines the company’s size of debt given the capital structure of the institution is given (Bodnar, Hayt, & Marston 1998). Sources of financial risks arise from organization's exposure to exchange rates, interest rates, and commodity prices. Another source of financial risks stems from an organization transaction with other organization such as customers, vendors, and counterparties in derivative transactions. The final sources of financial risk arise from private actions of an organization such as systems, processes, and people.
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Sources of financial risks
Venturing in any business is surrounded by financial risks hence it is important for the company to establish a better risk management strategy to run a successful business empire. All companies’ management systems have varying level of control over manageable risks and lack enough strategy and have no control over risks that are beyond the company’s’ management level.
Credit risks is a risk an institution incur when it extends its credit to customers or where the business suppliers increase the credibility to an institution. A business always faces the risk of customers default on payment whenever the company extends its purchase to customers. An institution should have enough amount of money to enable it to carry own its credit obligation by paying its bill in time. Failure to pay the loans might result to suppliers stop doing business with an institution or reduce the credit limit of a company. Credit risks become a worrying concern when an organization relies on another to pay its bills or when another organization owes money to that company. It is an issue a big issue, when the organization is not owed money on a net basis depending on the legal environment and whether money is owed on an aggregate or net basis. The deterioration of an organization credit quality is a basis for risk via the reduced market price of securities owned by an institution. All business and financial transactions expose an organization's credit risk depending on payment or fulfillment of the obligations to other partners. A derivative transaction is a credit risk that arises from exposure to counterparty risks. Credit risks increase when time to maturity, expiry, and settlement increases. International regulators take a bold move to reduce systematic risks by reducing the time to settle certain types of security that were exchanged in the market. Money owed through investment or lending arise the default risks of the borrower being unable or unwilling to pay.
Operation risks refer to different risks that arise from institution ordinary business activities. The risks may arise from fraud, human error, technology, systems, processes, and procedures. The most dangerous risk that an organization faces is operational risks due to the different prospects for losses that occur and the fact that the losses may be significant when the risk occur (Basch 2000). Operational risks involve procedural, process risk, system, and technology risk. Process and procedural risk involve adverse consequences of ineffective or missing the processes, control, procedure, or checks and balances. Inadequate control use in an organization is an example of procedural risk. On the other hand, technology and system risk integrate the organization's transactions and the operational risks arising from technology and systems, which support the processes.
Liquidity risk involves operational funding liquidity and asset risks. Operational funding liquidity is the daily cash flow in an organization. On the other hand, asset liquidity refers to the rate at which a business can exchange its assets within a short period when the need for extra cash flow in the company arises. Seasonal or general downturns in organizations revenue present the company without enough cash flow required to efficiently operate due to necessary expenses involved in running a business. Cash flow management determines an organizations success and is for this reason that analysts and investors assess the metrics of free cash flow while evaluating a company’s equity and investments (Sorescu, Chandy & Prabhu 2003). Liquidity affects a company's ability to sell or purchase a security or obligation for trading or hedging purpose and to close out an existing position. Indicators of liquidity include average bid, trading volumes, the number of financial institutions in the market, and sometimes price volatility.
Market risk is the risk of changing a particular market condition where the company competes. For instance, market risk is the growing tendency of customers to shop online. The phase of changing market state has created significant problems in the traditional retail business. Companies that have taken the shorter time to adapt to online shopping services provided to customers have thrived and enjoyed substantial revenue compared to the company that took a longer time to the changing market failed (Basch 2000). With narrowing profit margins in an increasingly competitive global marketplace, financially successful companies are the most successful in offering unique value propositions to make them outstanding from others and give them a stable market identity.
Financial risk management strategies
Some business risks occur due to an extraordinary circumstance, which is difficult to identify while other risks occur during the ordinary business operational course. Business threats must be identified as strategic of a plan of activities regardless of the company's success level or a company's business model. After determining the risk, the company then takes on the necessary steps to counter the risks and protect the business assets. Financial risk management deals with the uncertainties’ in the financial market. The analysis involves evaluating the financial risks and develops management strategies consistent with internal policies and priorities of an organization. The following are some business strategies.
Risk avoidance
The best and easiest way of an organization managing an identified risk is by avoiding the risk. An organization can stop engaging in activities involving risks. For example, a retail company can decline to buy a building for setting up a new shopping center because the amount of revenue that is likely to be generated from the business cannot be compared with the one for buying the building. Similarly, a small medical practice or a hospital may avoid performing certain high degree procedures for the safety of the patient due to high risks involved. The strategy results in potential loss of revenue, as the business is cautious to venture into another potential market.
Risk mitigation
Mitigating business risk reduces negative consequence or impact of identified risks; the strategy is used when the risk involved is unavoidable. For instance, a software company lessens the risk of a new program not operating correctly by discharging the program in phases. The strategy is used to mitigate the risk of capital waste.
Risk transfer
An organization may decide to transfer the identified risk to an insurance company by purchasing an insurance protection. Organizations sometimes transfer the risk away from the institution. For instance, property insurance company can be used to cover organization financial losses incurred when the risk strikes and damages a building or other business property.
On the other hand, financial service industry professionals may decide to buy an insurance cover that protects them from lawsuits arising from clients or customers claiming to receive erroneous or inadequate advice.
Risk acceptance
Organizations can implement risk management by accepting some level of risks. A company can maintain a risk brought by specific projects or business expansion. When the expected profit is much more than the risk identified, then an organization carry on its activities to achieve desired results if everything goes well (Basch 2000). A good example of risk where an organization accepts a risk is when a pharmaceutical company takes a risk in developing a new drug. The cost of researching on the new drug and development is less compared to the potential revenue that is likely to be generated from selling the new drug. Here the risk is considered acceptable.
References
Bodnar, G. M, Hayt, G. S., & Marston, R. C. (1998): Wharton Survey f Financial Risk Management by US Non-financial Firms. Financial management, 70-91.
Basch, C. A., Bruesewitz, B. J., Siegel, K., & Faith, P. (2000 ). U.S. Patent No. 6,119,103 . Washington, DC: U.S. Patent and Trademark Office.
Sorescu, A. B., Chandy, R. K., & Prabhu, J. C. (2003). Sources and Financial Consequences of Radical Innovation: Insights from Pharmaceuticals . Journal of marketing, 67(4), 82-102.
