Impacts of Financial Risks on an organization
Introduction
Financial risks are a huge concern for every organization. Understanding the impacts of financial risk is vital for any business or organization. Risks are part of any business operation, thus putting in place adequate risk management measures in the organization is crucial to ensure the organization is protected from financial ruin. Financial risks have the most adverse effects on an organization’s cash flow and overall bottom line (Jokhadze & Schmidt, 2020). All organizations are subject to financial risks exposure. Even with the best risk management strategies, not all financial risks can be avoided. For instance, stock market disruptions, interest rates changes and currency instability can affect all organizations negatively in terms of exposure to financial risk. This research paper will analyze the different types of financial risks, identify their impacts on organizations, and identify mitigation measures for the financial risks.
Financial Risk
Financial risks can strike at the core of an organization or business, thereby affecting its operating resources and ultimately affecting the organization’s cash flow. Financial risks can affect an organization in varied forms, such as customers falling to pay for services and purchases, risky operating decisions or a faulty business strategy. Because it is not possible to accurately predict the effects of financial risk, organizations should have adequate risk management strategies in their long-term plans. Businesses, on the other hand, should have tools to accurately predict potential risks and preparing strategies to cope with any of these financial risks. Financial risks can be categorized in different forms, including credit risk, liquidity risks, legal risks, market risks, operational risks and equity risks (Jokhadze & Schmidt, 2020). All of these risks affect an organization differently. Thus, a company should have different mitigation factors to help address these risks.
Credit risk
This is also referred to in other terms such as default risk. This risk occurs as a result of parties failing to fulfil their borrowing obligations. It is also known as settlement risk sovereign risks arising because of difficult foreign exchange policies that affect borrowing repayment terms (Moles, 2016). Credit risks can cripple the cash flow operations of an organization. An organization will lose money in case some customers fail to perform their payment obligations. For instance, when an organization delivers goods and supplies to a customer for 30 days, and the customer fails to honour their payment. This means that the organization has suffered from a credit risk from this specific deal. Therefore, to mitigate these risks, organizations should have adequate cash reserves that will cover their accounts payables such that they may not suffer from sudden cash flow problems.
Liquidity risks
This type of financial risk is also referred to as funding risk. It occurs when an organization is unable to execute transactions. This risk is usually categorized into two, namely, Asset liquidity risk and funding liquidity risks. The asset liquidity risks occur as a result of inadequate buyers or sellers against organizations to buy and sell orders. In simpler terms, this is the risks an organization faces when trying to raise funds or sell some of its assets. To counter this financial risk, an organization should have enough cash reserves and plan in case they plan to liquidate some of their assets. Liquidity risks also include interest rate risks and risks associated with currency risks. Cash-flows of an organization will frequently be affected in case of sudden fluctuations in the exchange rate or interest rates; thus an organization needs to have enough ash risks that will shield it from sudden liquidity problems that may affect the cash flow position of an organization.
Operational risks
This type of financial risks occurs as a result of operational failures within an organization. Operational failures may include technical failures, mismanagement. There are operational risks such as fraud risks, which may adversely affect the financial cash flows of business due to cases of financial fraud. Fraud risk mainly occurs because of a lack of adequate controls within the organization (Christoffersen, 2011). For instance, a bank losing money due to inadequate cybersecurity measures. This risk occurs as a result of the day-to-day operations of an organization, and therefore a business cannot avoid it. Issues such as lawsuits, financial theft, inventory loss, staff turnover may affect the company’s bottom line from time to time. An organization should have adequate control measures to protect itself against the effects of this financial risk.
Markets risks
This financial risk occurs as a result of the movement of prices in the financial markets. They can be categorized as directional and non-directional risks. Directional risks are the financial risks that happen as a result of movements in stock market prices, interest rates changes while non-directional movement occurs as a result of increased vitality risks. These can affect the value of an organization’s assets, liabilities; hence they have a direct impact on a company’s financial standing. A market risk can also affect organizations that fail to adapt to changing market conditions, which can affect the bottom line of a business and ultimately affect its cash flow position.
Equity risks
Equity risks mainly affect organizations trading in the stock markets. Volatile markets can render it impossible for a company to ascertain its value on the stock market (Cerchiello & Giudici, 2016). Sudden spikes on the stock market can adversely affect how a company operates; hence companies should have adequate risk management measures to protect themselves from sudden changes and volatility in the stock markets.
Legal risks
This is the type of financial risks that occur as a result of legal constraints facing an organization such as lawsuits. Whenever an organization faces financial distress due to the costs of legal proceedings, it is considered to be a legal risk.
Financial risk management
Organizations should have financial risk control measures to manage the impact of different financial risks. This is a process, it will largely depend on the business the company does, and the levels of risk the organization can take. The whole process of financial risk management will depend on what risks the company can absorb and having measures in place to ensure the risks do not affect the organization’s bottom line.
Conclusion
Financial risks can bring financial ruin and collapse of an organization. It is therefore crucial for an organization to understand the various risks affecting it and come up with measures to mitigate those risks so that they do not adversely affect an organization’s bottom line. Some risks, such as operational risks, legal risks, can be minimized while others require an organization to plan on how to mitigate them. It is up to an organization’s management to assess its risk exposure and come up with strategies on how to handle the organization’s risk profile and exposure.
Reference list
Christoffersen, P. (2011). Elements of financial risk management [Online]. Academic Press. Available from: https://www.dnb.com/resources/finance-credit-risk.html [Accessed 4 September 2020].
Cerchiello, P., & Giudici, P. (2016). Big data analysis for financial risk management[Online]. Journal of Big Data, 3(1), 18. Available from: https://journalofbigdata.springeropen.com/articles/10.1186/s40537-016-0053-4 [Accessed 4 September 2020].
Moles, P. (2016). Financial risk management. Edinburgh Business School[Online]. Available from: https://www.ebsglobal.net/EBS/media/EBS/PDFs/Financial-Risk-Management- Course-Taster.pdf [Accessed 4 September 2020].
Jokhadze, V., & Schmidt, W. M. (2020). Measuring model risk in financial risk management and pricing[Online]. International Journal of Theoretical and Applied Finance, 23(02), 2050012. Available from: https://www.researchgate.net/profile/Wolfgang_Schmidt/publication/338953649_Measur ing_model_risk_in_financial_risk_management_and_pricing/links/5ef9b5d0299bf18816e ffe30/Measuring-model-risk-in-financial-risk-management-and-pricing.pdf [Accessed 4 September 2020].