Terms Beginning With 'f'

Financial Risk

  • February 04, 2021
  • Team Kalkine

What is Financial Risk?

Financial Risk is the risk of losing money on an investment. The investment may be a business venture or a financial asset that holds the potential to generate income.

An enterprise can face various financial risks and many types of dangers that can harm the business or investments, causing capital loss. With financial problems, a company can face resource crunch and hurt cash flow. Customers who fail to pay, vendors delaying the products, or even an unsuccessful business strategy can hurt the businesses financially. Businesses also run the risk of being dented by circumstances outside their control such as the economy, policy, and law changes. Such situations can threaten a company's financial growth and profitability.

Therefore, many enterprises invest money towards financial risk management to secure their business from crashing. With proper risk management, businesses can ensure a fulfilling outcome.

Not just big corporations but governments can also face financial troubles. Poor monetary policy or debt-related issues can create considerable financial burden on governments.

Individuals also face financial trouble that can hamper their income or liquidity crunch.

What are the various types of financial risks?

Image source - © Kalkine Group 2021

  • Borrower's risk – commonly known as credit risk. It involves the financial risk associated with oversized debt from loans, credit cards and others. Sometimes, when a company is operating on borrowed money, it could hurt the business if not appropriately managed. Also, too much risk can drive the industry to ruin.
  • Economic risk – while doing business in other countries, factors such as macro-and microeconomic can pose a threat. There are various institutions which provide details of the nations around the world and their risk levels. Before expanding the businesses, it is essential to calculate all the risks and opportunities.
  • Specific risk – when a select few companies are struggling with issues related to capital structure, financial transactions, it is referred to as specific risks. The term represents the investors’ uncertainty of collecting returns, which can result in monetary loss.
  • Operational risk – operational risk is usually based on a company's internal factors. Few companies face this risk because of an unhealthy management and flawed financial structure.

Why Risk Management is important?

Risk management helps the businesses identify the possible risks, analyse them and provide solutions to trim down the losses. Risk management can be especially instrumental while taking investment decisions during uncertain times.

Risk management process is conducted when investors and fund managers analyse the risk level of the investment before making decisions. Based on the results, they can quantify the losses beforehand and take appropriate actions or inactions and hedge the risk. It solely depends on the investors' objectives and risk-taking capacity. More often than not, every business venture and every investment has some level of risk involved.

Condition in which potential loss from the risk is not enough to spend money on it to avoid the risk. Such cases emerge when the risk is either too less or very unlikely to occur.  

Net amount after factoring in all debits and credits in a financial repository at a given moment. If an account balance drops below zero, it demonstrates a net debt.

A Professional who conducts audits and Financial Statement Analysis. They have the required competency with educational or professional certifications to use titles related to accountant

What are accounts payable? Accounts payable is the amount of cash a company is liable to pay to its suppliers and clear dues. As current liabilities of the company, accounts payable is required to be settled over the next twelve months.  It also shows the obligations of the business over the next year. Accounts payable is required to be repaid in a short period, depending on the relationship with suppliers. It is essentially a kind of short term debt, which is necessary to honour to prevent default.  As a part of the company’s working capital, it is widely used in analysing the cash flow of the business and cash flow trends over a period. Accounts payable may also depict the bargaining power of the company with its vendor and suppliers.  A vendor or supplier may give the customer longer credit period to settle the cash compared to other customers. The customer here is the company, which will incur accounts payable after buying goods on credit from the vendor.  There could be many reasons why the vendor is providing a more extended credit period to the firm such as long term relationship, bargaining power of the firm, strategic needs of the vendor, the scale of goods or services.  By maintaining a more extended repayment period to supplier and shorter cash realisation period from the customer, the company would be able to improve the working capital cycle and need funds to support the business-as-usual.  However, prudent working capital management calls for not overtly stretching the payable days as it might lead to dissatisfaction of supplier. Also, investors tend to closely watch the payable days cycle to determine the financial health of the business. When the financial conditions of a firm deteriorate, the management tend to delay the payment to their suppliers. What is accounts payable turnover ratio? Accounts payable turnover ratio shows the capability of a firm to pay cash to its customer after credit purchases. It is counted as an essential ratio to analyse the cash management attribute of the firm and its relationship with vendors or suppliers.  It is calculated by dividing purchases by average accounts payable.  Purchases by the company are calculated as the sum of the cost of sales and net inventory in a given period:  Now let’s understand this the help of an example. Let us suppose, Cost of sales of Company XYZ for the period was $60,000, and XYZ began with inventories worth $21000 and ended at $15000. Accounts payable at the beginning was $20000, and $15000 at the end.  Now the purchases will be $66000 (60000+21000-15000). The average accounts payable will be $17500. Therefore, the accounts payable turnover ratio will be 3.77x.  Dividing the number of weeks in a year by the accounts payable turnover ratio will give the number of weeks the company takes on average to settle its payables. In this case, it will be around 13.8 weeks (52/3.77). 

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