What Are the 4 Main Financial Risks When Running a Business?
Understanding the financial risks of your business is probably the first step to reducing it. In this article, we will address four types of financial risks a business is exposed to:
- Foreign exchange risk
- Interest rate risk
- Liquidity risk
- Counterparty risk
Foreign exchange rate risk (FX risk)
The risk of managing transactions in foreign currencies is probably the most well-known and best understood risk to companies doing business internationally. If not well managed, FX risk creates a net exposure that can affect severely profit margins and lead to substantial losses.
Three common situations in which FX risk arises:
TRANSACTION RISK is associated with a change in the exchange rate between the time a company initiates a transaction and settles it. This risk arises when a company has contractual cash flows (accounts receivable and payable) in foreign currencies because those values are subject to unanticipated changes in exchange rates.
Example: A Hong Kong-based company will receive a EUR payment from a European customer in three months. If the value of the EUR falls, the company will bear an exchange loss (i.e. when the EUR is converted to HKD the company will have less HKD).
ACCOUNTING RISK OR TRANSLATION RISK arises when a foreign subsidiary maintains financial statements in a currency different from the one used by its parent company.
Example: A parent company based in Spain acquires a UK-based company. If the GBP drops in relation to the EUR, then the UK company’s financials will impact the parent company’s balance sheet.
ECONOMIC RISK is the risk that adverse currency movements will affect the competitiveness of a company.
Example: If EUR/HKD depreciates faster than EUR/GBP, companies based in Hong Kong will lose their competitive position to those located in the UK. Why? When bidding for a project in EUR, the Hong Kong company will increase its price quote in EUR more than the UK company to make sure it collects the original amount of HKD it wanted.
Interest rate risk
This risk arises when interest rates change. If interest rates rise, a company that has variable-rate debt will end up paying more interest. This may negatively affect the company’s profit margin if not outweighed by other factors.
Example: Companies with variable-rate loans see the interest rate they pay change based on LIBOR* rates, usually on the three-month rate. If a company has a five-year loan based on the LIBOR 3-month rate + 2%, the repayment will be made every three months and the amount to be paid will be calculated based on the LIBOR 3-month rate. The company will pay less if the rate falls and vice versa.
* This is the London Interbank Offered Rate, or average interest rate at which leading UK banks borrow money from other banks.
It is often difficult for SMEs to get credit from financial institutions. They often require that a company:
- be in business for at least six months (if not a year),
- meet the minimum annual revenue requirements, and
- have a good credit score (i.e. good loan repayment record).
Typically, a company newly incorporated in Hong Kong with less than a six-month track record will find it difficult to get a loan from their bank. In 2016, the Hong Kong Monetary Authority (HKMA) commissioned the Hong Kong Productivity Council (HKPC) to carry out a quarterly survey on SMEs’ credit conditions.
This is the risk that a business partner does not fulfil its contractual obligation when an agreement comes to maturity. Every company wants to avoid having a credit risk over a counterparty. When a client fails to pay, it can be a nightmare for a company with dire consequences, including the worst scenario – bankruptcy.
Counterparty risk can exist in credit, investment and trading transactions.
In addition to these four types of financial risk, companies are also exposed to other specific risks, such as systemic, operational and reputational risk.
Statrys treasury guide aims to provide a detailed picture of the financial risks faced by companies and the solutions that can be implemented to manage those risks.