Financial Risk and Non Financial Risk: What You Need to Know

Financial risk and non-financial risk are two sides of the same coin. They both have the potential to impact your business, but they are managed and mitigated in different ways.

Financial risk is often the most obvious type of risk, and it's typically quantifiable. For example, a company may have a 10% chance of losing $100,000 in a single quarter due to market fluctuations.

However, financial risk is not the only risk that businesses face. Non-financial risk can be just as damaging, and it's often harder to quantify. This type of risk can include things like a loss of key employees, a decline in customer satisfaction, or a failure to meet regulatory requirements.

Non-financial risk can be just as costly as financial risk, and it's often more difficult to recover from. For instance, a company may lose millions of dollars in revenue due to a decline in customer satisfaction, but it may take years to rebuild trust with its customers.

Financial risk can be unpredictable and far-reaching, affecting both private and public entities. Credit risk, for instance, is the likelihood that a customer or borrower will fail to meet their financial obligations, such as payments.

Credit risk can be mitigated through insurance and collateral, but some parties may still default. Credit checks are a common means of evaluating a customer or borrower's eligibility for deferred payments.

There are several types of financial risk, including credit risk, market risk, liquidity risk, operational risk, legal risk, and foreign exchange risk. These risks can be managed through best practices in financial instruments, portfolio management, budgeting, and asset management.

Here are some of the key types of financial risk:

By understanding these types of financial risk, organizations can take steps to mitigate them and make more informed financial decisions.

There are six types of financial risks that face companies, including operational risk, credit risk, market risk, liquidity risk, legal risk, and foreign exchange risk. These risks can impact an organization's financial stability and decision-making.

Operational risk involves the likelihood of losing money due to internal processes, systems, or people. Credit risk occurs when a borrower fails to repay a loan. Market risk is the uncertainty of stock prices rising or falling.

Liquidity risk happens when a company can't meet its short-term financial obligations. Legal risk involves the potential for financial loss due to non-compliance with laws and regulations. Foreign exchange risk occurs when exchange rates fluctuate, affecting a company's financial performance.

Here are the six types of financial risks in a concise list:

Credit risk is the risk that a customer or borrower fails to meet their financial obligations, like payments.

Companies can take steps to mitigate credit risk through insurance and collateral, but some parties may default regardless.

Credit risk is the chance that a business may lose money because of a customer not making payments according to the terms of a contract.

Banks, insurance companies, and lenders require applicants to undergo credit checks to understand the risk of working with a potential customer.

Accepting or lending money to a client with a history of missing payments or defaulting on loans can be a risk to your business.

An entity's credit score measures their likelihood of paying debts back on time.

Automated credit scoring technology is widely used by credit card companies, banks, and buy-now-pay-later (BNPL) agencies to approve applications faster.

This technology analyzes the credit history to identify defaults, late payments, and other factors that deem an applicant non-creditworthy.

More informed decision-making for financial institutions is possible with automated credit scoring technology.

Stock market risk is unpredictable, with volatility, timing, and overconfidence being the primary risks. Volatility is the rise and fall of prices caused by various factors, like geopolitical events, inflation, and economic events.

The odds of stock prices rising or falling are unpredictable, making it difficult to make informed decisions. Timing also affects stock market risks, such as buying and selling at specific times during the day or week based on past patterns.

Overconfidence is an internal risk stemming from an investor taking unnecessary risks. For instance, buying too many assets in one industry or using intuition instead of qualitative data to make decisions.

Here are some key factors to consider when it comes to stock market risk:

Stock market risks can affect interest rate risk, currency risk with foreign exchange rates, and stock market valuation. It's essential to understand the intrinsic value of securities and calculate the true value of stocks before purchasing or exchanging them.

Liquidity is a critical aspect of financial risk, and it's essential to understand its impact on organizations.

Liquidity risk is the inability to meet financial obligations due to a lack of cash or funds. It's an existential threat to an organization and can even lead to a going-concern risk.

Managing cash flow, liabilities, and assets in a balanced way can help organizations limit liquidity risk.

Anything standing in the way of increasing cash quickly is considered a liquidity risk, such as a mortgage company struggling to sell homes during an economic downturn.

Asset liquidity refers to how easily an entity can convert their assets into cash, and it's determined by an entity's ability to repay its debts without incurring severe losses.

Liquidity risk occurs when the individual, company, or institution has to sell their assets at a lower value than they acquired it for, which can result in bankruptcy.

In essence, liquidity risk is the inverse of credit risk, where the organization is unable to make payments due to a lack of cash or funds.

Operational risk is any disruption that stops a business's operation. For example, the COVID-19 pandemic caused banks and other financial institutions to limit their operations.

Operational risk can be caused by various factors, including lawsuits, theft, fraud, staff turnover, and poor budgeting. Mismanagement of a company's functions, finances, and/or its employees can also result in high operational risk.

Operational risk encompasses any unforeseen events in day-to-day operations that could have an effect on the company’s bottom line. This can include a manufacturing plant or data center going out for several hours, resulting in a loss of revenue.

Monitoring funds is crucial to managing operational risk, and it's not just about keeping track of expenses. Financial institutions package assets into asset-backed securities and sell them to institutional investors as mutual funds, which can lead to cash flow issues if payments aren't made on time.

Companies can equip employees with prepaid physical or virtual payment cards with spending limits to prevent overspending on business and travel expenses. This helps finance teams budget smarter and facilitates business growth with lower credit risk and bankruptcy risk.

Real-time fund monitoring provides a 24/7 overview of company spending behaviors, enabling finance teams to manage company subscriptions more effectively. By proactively checking for and removing inactive subscriptions, companies can avoid wasting budget on tools that are no longer of value to their teams.

Regular risk assessments should be scheduled at least annually, and quarterly meetings with key stakeholders can help discuss and manage financial risks. These periodic risk assessments serve as benchmarks for the company, demonstrating progress year-over-year and helping businesses prepare for potential financial pitfalls.

Operational risk is any disruption that stops a business's operation. This can happen due to various reasons such as lawsuits, theft, fraud, staff turnover, and poor budgeting.

Operational risk can be caused by internal factors like mismanagement of a company's functions, finances, and/or its employees. It can also be triggered by external events like the COVID-19 pandemic.

Having a manufacturing plant or data center go out for several hours can result in a loss of revenue for the business. This highlights the importance of having mitigation strategies in place to limit operational risk.

Companies can collaborate between their financial risk management (FRM) and operational risk management (ORM) teams to tackle and manage potential risks for increased effectiveness. This can help them continue to thrive in spite of any residual risk.

Some common examples of operational risk include:

Implementing governance, risk, and compliance (GRC) software is necessary for maintaining compliance and detecting fraud and insider trading. This software can help risk departments analyze unclear human communication using natural language processing.

Legal risks can include the risk of financial loss due to lawsuits, like with a defective product causing bodily injury.

The risk of noncompliance can lead to fines and lost sales, which is a significant concern for any organization.

Failing to meet legal, regulatory, or compliance requirements can have severe consequences, including financial loss and damage to reputation.

Integrating FRM with the organization's larger enterprise risk management function ensures that risks don't fall through the cracks between silos.

This collaborative approach encourages a proactive approach to risk management, which can help prevent costly mistakes and lawsuits.

Risk management is a crucial aspect of financial and non-financial risk. It involves identifying, analyzing, and mitigating risks to minimize their impact on your business.

To manage financial risk, you need to define risk management, understand its features, and establish a risk governance framework. This includes identifying financial and non-financial sources of risk and describing how they may interact.

Risk tolerance affects risk management, and risk budgeting plays a significant role in risk governance. By setting a risk budget, you can allocate resources to mitigate risks and prioritize risk management initiatives.

Here are some common risk treatments: risk acceptance, risk avoidance, risk transference, and risk mitigation. Each risk requires a treatment plan, and ideally, a mitigation plan would reduce the risk score to a tolerable level.

By applying risk management techniques, such as regression analysis, value at risk (VaR) analysis, security analysis, and scenario analysis, you can analyze and mitigate financial risks. These techniques help you understand the potential impact of risks and make informed decisions.

To effectively manage risk, you need to understand the basics. Risk management is a process that helps organizations identify, assess, and mitigate potential risks.

A risk management framework is essential for this process. It provides a structured approach to identifying and assessing risks, and helps organizations prioritize their mitigation efforts.

Risk governance is a critical component of risk management. It involves setting policies and procedures for risk management, and ensuring that risk management is integrated into an organization's overall strategy.

Risk tolerance plays a significant role in risk management. It refers to an organization's willingness to take on risk, and can affect its risk management strategy.

Risk budgeting is another important aspect of risk management. It involves allocating resources to manage risks, and helps organizations prioritize their risk mitigation efforts.

Sources of risk can be financial or non-financial. Financial sources of risk include credit risk, market risk, and liquidity risk. Non-financial sources of risk include operational risk, reputational risk, and compliance risk.

To measure and modify risk exposures, organizations can use various methods, including risk assessment, risk modeling, and stress testing. When choosing a method, organizations should consider factors such as the complexity of the risk, the availability of data, and the level of expertise required.

In small businesses, the owner is responsible for managing financial risk.

As a business owner, I've seen firsthand the importance of taking on this responsibility, especially when it comes to making tough financial decisions.

In larger companies, senior managers are responsible for risk management within their departments.

This can be a complex task, but it's essential for identifying and mitigating potential risks before they become major issues.

Enterprises often hire a dedicated financial risk manager to make recommendations and help prevent and mitigate risks as they arise.

This professional brings a level of expertise and objectivity to the risk management process, which can be invaluable in helping the company navigate challenging financial situations.

To effectively manage risks, you need a clear plan in place. This plan should include several key components.

A financial risk assessment plan is essential for identifying, analyzing, and mitigating financial risks. Before conducting a financial risk assessment, companies should establish clearly defined risk tolerance thresholds.

These thresholds indicate how much risk the organization is willing to take on and should be used to guide decision-making. By setting these thresholds, companies can ensure that their risk management efforts are aligned with their overall business objectives.

Here are the key components of a financial risk assessment plan:

By incorporating these components into their risk management plan, companies can effectively identify, analyze, and mitigate financial risks, ultimately reducing the likelihood and impact of adverse events.

Credit scoring technology can help you make informed decisions about lending or accepting payments from customers. It's widely used by credit card companies, banks, and buy-now-pay-later agencies to get applications approved faster.

Automated credit scoring technology analyzes credit history to identify defaults, late payments, and other factors that deem an applicant non-creditworthy. This allows for more informed decision-making for financial institutions.

Companies can take steps to mitigate credit risk through insurance and collateral, but some parties may still default. Organizations should understand and benchmark any historical instances of credit defaults to manage future credit risks.

Credit checks are another common means used to evaluate a customer or borrower's eligibility for deferred payments. This can help prevent buyers with poor credit from taking out loans and flag high-risk transactions.

Banks, insurance companies, and lenders require applicants to undergo credit checks to understand the risk of working with a potential customer. Accepting or lending money to a client with a history of missing payments or defaulting on loans can be a risk to your business.

To mitigate financial risks, businesses can take steps such as minimizing cash-flow volatility and adjusting loan interest rates to make financing costs more certain.

Minimizing cash-flow volatility involves managing operational costs, creating rigid procedures for better billing and credit control, and managing payment terms. This can be achieved by cutting off customers abusing credit terms and reducing the risk of fraud by hiring and training staff to use proper tools and procedures.

Spotting and reacting to fraudulent purchase behavior is also easier when companies can quickly freeze and control company cards from one digital platform, mitigating operational risks like credit card fraud and expense report fraud.

Some practical steps to prevent fraud include:

To make mitigation plans, you need to analyze the risks and determine if your business can survive the risk exposure. This involves considering your company's goals, the market, and your appetite for risk.

You can minimize cash-flow volatility by adjusting loan interest rates to make financing costs more certain. This will help you better manage your finances and reduce the risk of unexpected expenses.

Managing operational costs is also crucial in mitigating risks. This can be achieved by creating rigid procedures for better billing and credit control, and managing payment terms.

Cutting off customers who abuse credit terms can also help reduce the risk of financial losses. You should also reduce the risk of fraud by hiring and training staff to use the proper tools and procedures.

Here are some steps you can take to make mitigation plans:

Preventing fraud is a crucial aspect of financial risk management. By having a clear view of who makes every payment and where the money goes, you can mitigate operational risks like credit card fraud and expense report fraud.

To prevent fraud, it's essential to have a means to detect it. This brings the need for document processing and fraud detection software, such as Inscribe's solution that uses AI and machine learning.

With Inscribe's software, customers can submit necessary documents to prove identity, address, and income. The software analyzes each document to determine its authenticity, and if it's fake or altered, you're notified to review.

Inscribe also scores applicants based on their bank statement data, pulling data points to determine their spending habits and trustworthiness.

To minimize cash-flow volatility and reduce the risk of fraud, consider implementing rigid procedures for better billing and credit control, as well as managing payment terms and cutting off customers abusing credit terms.

Here are some specific steps you can take to prevent fraud:

To effectively manage financial risk, you need the right tools. Digital financial risk management tools can significantly reduce errors and speed up processes.

Using artificial intelligence and machine learning can assist with financial risk management by detecting fraud, underwriting loans, and modeling credit losses.

Staying compliant isn't optional; it's a legal requirement. Governance, risk, and compliance (GRC) software is necessary for this reason.

Specialized software with natural language processing can help risk departments analyze unclear human communication, which is critical for detecting fraud and insider trading.

Implementing GRC software can be complex because it spans across departments. But once you do, you get a high-level view for better analysis.

Creating a financial risk management system complete with processes and tools can reduce human errors and increase security for your company.

A tech stack encompassing all aspects of risk, including cybersecurity, fraud, and investment decision-making, can help minimize the risk of financial loss.