As a business owner, you will often wear multiple hats and juggle multiple issues to run your company smoothly. One major issue that is high on the priority list is risk management. No business can be completely free of risk, which is why it’s critical that business owners know how to identify and reduce two major types of risk: business risk and financial risk.
Business and financial risk may share certain similarities, but they are distinct from each other and require different approaches to balance and mitigate them. So, how can you tell the difference between the two, and what can you do to minimise your risk exposure? Here’s how to distinguish between business and financial risk and the strategies to effectively manage them.
What is business risk?
Business risk refers to the fundamental ability of a company to generate sufficient revenue to cover its operating expenses and achieve profitability. It includes all non-financing risks that can affect a company’s viability, from its daily operations to external market factors. This type of risk can arise due to fluctuating market conditions, changes in consumer demand, evolving government regulations, and economic shifts.
Unlike financial risk, which is tied to a company’s capital structure, business risk focuses on operational challenges such as production efficiency, employee performance, and the organisation’s ability to adapt to industry changes. For example, increasing competition or supply chain disruptions can pose significant business risks by reducing profit margins.
According to Allianz Risk Barometer 2024, cyber incidents such as ransomware attacks, data breaches, and IT disruptions are the biggest worry for companies globally in 2024.
In addition, business risk can be broken down further into five main categories:
1) Security and fraud risk
Includes data breaches, cyberattacks, identity theft, and embezzlement. The International Monetary Fund (IMF) has warned that the “global financial stability is under threat from the increasing frequency and sophistication of cyberattacks.” ”
2) Compliance risk
Refers to adhering to laws and regulations that apply to your business. Failure to comply can lead to hefty fines or reputational damage. For instance, Singapore’s Personal Data Protection Act (PDPA) has seen increased enforcement in recent years.
3) Operational risk
Includes internal, external, or a combination of both kinds of risks. For example, a pandemic that forces people to work from home or human error in an operational process.
4) Financial or economic risk
These are risks related to market movements, foreign currency exchange rates, commodity price fluctuations and more. These risks can significantly affect a company’s profitability, financial stability, and overall operational strategy.
5) Reputational risk
Providing faulty products or services, poor customer support experiences, negative publicity and more. According to Deloitte, nearly all executives surveyed rated reputation risk as highly significant among other strategic risks.
What is financial risk?
While financial risk is considered a type of business risk, it has its own considerations and factors that require a different mitigation approach. Unlike business risk, financial risk is linked to the company’s borrowed capital and ability to service its debt.
Companies with higher debt levels face increased financial risk due to the possibility of defaulting on their loans or becoming insolvent. Key factors contributing to financial risk include interest rate fluctuations, debt-to-equity ratios, and foreign exchange rate volatility for companies operating internationally. For example, significant currency fluctuations can erode profitability, particularly for businesses with substantial cross-border transactions.
Financial risk can be drilled down deeper into several different categories:
1) Market risk
Arises from changing market dynamics, such as shifting consumer preferences. Businesses that fail to adapt risk losing their competitive edge.
2) Credit risk
Providing customers with financing options or the business’ payment and credit terms with its suppliers. A study revealed that Asian businesses are taking longer to convert working capital in cash, affecting liquidity.
3) Liquidity risk
How quickly a business can convert its assets to cash (asset liquidity) and its daily cash flow (operational funding liquidity). SMEs in Asia-Pacific reported liquidity challenges as one of their top concerns in 2024.
4) Operational risk
These include risks like manpower issues, potential fraud, lawsuits and more.
How companies can mitigate business and financial risks
Although there will always be varying levels of risk for any business, using the right strategies can reduce the amount of business and financial risk exposure.
Create a contingency plan and risk management framework
As a first step, ensure that you have a clear risk management plan in place based on your industry’s best practices to help you identify and prioritise the main types of risk to address.
Once you have determined this, outline detailed steps and procedures to manage your business and financial risks in order of importance.
Conduct pre-employment screening
A major part of business and financial risk includes operational, security and compliance risks. Reinforcing these areas will ensure that you minimise the ways your business can be compromised.
One method to do so is by having pre-employment background screening. With up to 75 per cent of HR leaders catching falsified information on resumes at least once in their careers, these background checks act as a vital layer of protection to mitigate fraud and reputational risks as they will help to verify important personnel information, including educational qualifications, employment history and criminal records.
In addition, performing in-depth background research for suppliers and partners can go a long way in reducing security and compliance risks. By getting deeper insight into these entities, your business will better understand your business partners, reducing potential compliance issues.
Additionally, screening new senior hires for their financial health is highly recommended, especially if they’ll have access to sensitive financial and business information.
Build a risk culture
Establishing a risk culture in your business can ensure that all employees share the same mindset towards risk management. Business leaders must take the steps to be committed to developing this culture and be proactive to risks.
Raising risk awareness through communication and training, providing the right reporting channels and enforcing personal due diligence are also essential for mitigating business and financial risks.
Review financial health regularly
Ensure that you keep a close eye on business finances by reviewing and analysing your financial data on a regular basis. This will help you better understand your company’s financial health and guide you to make the right decisions when it comes to strategic financial planning.
Regular reviews allow you to maintain accountability, keep figures accurate, and make corrections if your business is headed into riskier territory.
Maintaining good financial health also means managing your cash flow and liquidity well. The right combination of credit use and plentiful cash reserves can help reduce your liquidity risk.
While business and financial risks can sometimes overlap, they often require different mitigation strategies. As such, businesses must prepare the right approaches to mitigate these risks. When getting suitable solutions for risk management, getting in touch with an expert like RMI can help simplify the process. Contact us today to learn more about our business and financial risk management solutions.
