Is it really necessary to be able to manage financial risk? The answer is a definite “Yes!” It can make the difference between having a successful business or being forced to close down the business. Make sure you give your business the best chance to survive and thrive by understanding and implementing financial risk management.
Financial risk management can be broken down into the following steps:
- Understand what financial risk is
A financial risk is any event or circumstance that can have a potentially negative impact on the finances of a business.
- Identify financial risks applicable to the business
Identify all the financial risks that you can think of which can have an impact on the business. Consider using brainstorming with employees and/or a SWOT analysis to help you identify as many potential risks as possible.
An example of a financial risk is that customers who buy on credit from your business will not be able to pay their outstanding accounts.
- Assess each financial risk separately
Estimate as well as you can with the available information how probable it is that each risk can affect the business and what the possible amounts of the damage (negative impact) could be if the risk should realise.
Taking the example of customers who will not be able to pay their outstanding accounts, the following matrix is handy to assess the probability and extent of the damage should the risk realise. Assume that the probability and potential damage of clients not being able to pay their outstanding accounts are high as indicated on the matrix with “X”.
|Probability of damage occurring (clients not able to pay accounts)|
|Estimated extent of damage||Major damage e.g. R100 000||X|
|Medium damage e.g. R30 000|
|Minor damage e.g. R5 000|
- Treat risks to limit negative impact on business
Select and treat those risks you have the most control over to focus your financial risk management efforts on. Control in this context will be the ability to minimise the chances and potential damage caused if the risk should realise.
Create and implement an action plan to reduce each of the selected risks to acceptable levels.
Consider using insurance to protect the business against external risks which the business does not have much control over e.g. natural disasters.
To continue with the example: the matrix shows that it is highly probable that clients won’t be able to pay their accounts, and the amount of the resulting bad debts can be major. There are measures that the business can implement to prevent, or at least decrease, the likelihood and the amount of damage due to bad debts. These are the measures that the business should focus on implementing to reduce the risk of bad debts occurring to acceptable levels. Preventive measures could include checking the credit record of customers before selling on credit to them and implementing a pre-approved credit limit per customer.
- Monitor the financial risk management plan
Review the financial risk management plan regularly to ensure that it stays up to date with the changing circumstances of the business and remains effective to decrease current financial risks.
Using the above example of potential bad debts, the regular inspection of the debtors’ age analysis might show an increase in long outstanding amounts which can indicate that the credit policy for clients needs to be reviewed and updated.
Proper financial risk management can greatly increase a business’ chances of being successful and profitable. If you would like to implement a financial risk management plan or suspect that the financial risk management plan currently in use might be outdated, do contact your accountant for professional assistance.
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)
- Risk management guide for small to medium businesses, 2009, CPA Australia