What is Financial Risk? Types and How to Measure Financial Risk?

. 6 min read
What is Financial Risk? Types and How to Measure Financial Risk?

Financial risk is involved in almost every business. However, a small number of entrepreneurs are familiar with this word. The word financial risk implies the likelihood of losing money on a business or investment. Financial risk can also be a type of peril that can lead to loss of capital. It can be faced by both the government and a monetary establishment.

Financial institutions may face financial risk from various factors, changes to the market interest rate, and the possibility of default by various sectors or large corporations. Individuals face it when their decisions hamper their earnings and keep them from paying their debts. However, financial risks are present everywhere and come in numerous forms.

What are the Different Types of Financial Risks?

As said earlier, there are financial risks everywhere that can lead to enormous quantities of losses. Thus it becomes a necessity to examine and evaluate these risks and minimise them too.

It is crucial to analyse these risks, but before that, you must understand the major types of financial risk that may endanger a business organisation. Here are the four main financial risks that must be understood before taking any steps to deal with the financial risks.

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1. Market Risk

The most significant type of all types of financial risk is market risk. This type of risk has a wider expanse as it depends upon the supply and demand trends of the market.

Market risk is the type of risk that impacts all the companies in the market and not only on a single company. The sources of market risk involve fluctuations in the prices of assets and liabilities.

One example of market risk is when companies who keep up with technological advancements experience a smooth revenue flow, the ones who do not adapt to it, lag and experience losses. Here technological advancement forces a change in the market. Hence, it impacts every business, only a single company.

2. Operational Risk

Operational risk is also one of the types of financial risk. The operational risks are the ones that mostly occur due to an absence of internal management of the company. Other factors which are responsible for operational risks are mismanagement, no employee training, and technical failures.

This risk eventually leads to the financial loss of the business. To calculate this risk accurately, the organisation must have a record of the past failures of similar types and analyse if there is a connection between them. These risks can be avoided if a particular risk is thought to initiate more risks.

For example, if a machine breaks down, it not only disrupts the whole process but also needs additional expenses for fixing up. It furthermore leads to extra loss if the production process comes to a halt and the product supply plunges.

3. Credit Risk

Credit Risk is the most important type of risk that is considered in financial risk management. This risk refers to the possibility that creditors may not receive their loans' payment or receive it late.

Credit risk is of two types- retail and wholesale.

The retail credit risk implies the risk involved when we finance an individual or small business through various means such as card, mortgage, or cash.

Wholesale credit risk originates from the company's investment in various things such as the acquisition of other companies, sales of the organisation's assets, etc.

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4. Liquidity Risk

Financial risk management also includes the liquidity of a company. Every business organisation must ensure that it has adequate income to pay off the debts. Failing to pay back the debts may ruin the confidence of the investors.

Liquidity risk is exactly this. It is the possibility that a company will not be able to fulfil its commitments. And one of its reasons is poor cash flow management.

A company that may have a good amount of equity still may have high liquidity risk. It happens because the business cannot turn those assets into money to meet its expenditures.

Some examples of assets that may take a long time to turn into money are bonds and real estate. Therefore a company must verify if it has existing assets to pay off short-term shortages or debts.

How to Measure Financial Risks?

Since we cannot deny that financial risks are involved with every business and investors usually analyse these risks to expect greater returns, let us understand the common ways one can measure financial risk in a business.

It must be noted that a single measurement will not suit every business. Therefore a business or a sector must be taken into context before a risk measurement is considered.

  • Debt to Income

Before investing in a company, they may just look at the income of a business organisation instead of the assets. The debt to income ratio is the net debt divided by the income of the company.

  • Debt to Asset

When the financial risk is associated with a company's debt, the simplest option to measure the financial risk of the company is to look for the debt to asset ratio. If a company owns assets valued more than it owes, then the financial risk is lesser, and it is an attractive opportunity for investors. However, if the amount owed by the company is higher than it owns, the risk is higher.

  • Debt to Equity

This measurement is generally used in high financial risk situations. In the debt to equity measurement, the assets funded by debt are taken into consideration. It can be measured by dividing the debt by the shareholder's equity. A lower ratio is chosen to show that the company is operating with its resources rather than debts.

  • Cash flow to Debt

When a low-risk business is considered, cash flow to debt is used to measure the financial risks involved. This ratio is calculated by taking cash flow to service debt divided by debt. Though there are numerous other ways to calculate the ratio, this is the most used method.

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  • Equity Multiplier

The equity multiplier is also known as the financial leverage multiplier. The number of a company's assets, funded by the shareholders, is measured in this method of risk measurement. In the equity multiplier method, the total assets of a company are compared with the shareholder's equity. It also highlights the level of finance from debts used to amass assets and continue its functioning.

Wrapping it up

So these were the types of financial risks and the methods that can be employed to measure financial risks involved with the business. Measuring risks is crucial for investors as they expect high returns from every investment. Thus investors must know these methods to take calculated risks before investing in any business. These risks must also be known to entrepreneurs so that they can make well-informed decisions for their companies.

Also Read:

1) How To Calculate Long Term Capital Gains (LTCG)?
2) Financial Areas Businesswomen Should Focus On
3) What goes into starting a fintech company?
4) 10 Things Every Business Owner Can Learn About Money Management from Women

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Q. What are the steps to analyse financial risk?

Ans. To analyse financial risk, a financial risk model must be developed. This model gives a quantitative approach to analyse risk. Making spreadsheets, getting risk management software, and developing a customised solution are the three steps to be followed in the financial model.

Q. How can a company manage risks?

Ans. Some common ways for a company to manage risks are carrying insurance, keeping funds for emergencies, modifying investments, having extra sources of income, etc.

Q. How to identify financial risks?

Ans. There are various ways to identify financial risks. But the most common ways to do so is to brainstorm, think pessimistically, and seek feedback from employees.

Q. What are the other types of risks apart from the major ones?

Ans. The other types of financial risks are foreign investment risk, interest rate risk, stock market risk, and currency risk.