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How to Manage Financial Risk in your Business

Managing financial risk is a basic necessity in running any business. Besides mitigating financial damage, proper risk management helps among others, to optimise earnings, ensure the smooth execution of day to day operations, and prevent reputational damage.

A comprehensive risk management plan can help to anticipate future issues, such as delayed payments or defaults, along with the conventional ups and downs of the business cycle.

SMEs don’t need to imitate large companies in dedicating entire departments to risk management or committing vast resources to it; risk management practices can scale with the business in question. For smaller businesses, it’s possible to lower risk by covering four basic forms of it:

  • Market risk
  • Credit risk
  • Liquidity risk
  • Operational risk

1. Market risk

This refers to risks that come from the overall business environment itself. As the ASEAN region grows more integrated, for example, local businesses may find their market share threatened by competitors with cheaper or more advanced products.

Besides the emergence of new competitors, businesses will face the usual consequences of changes in the cycle. Manufacturing output may shrink as a result of political disputes, or through government policy intervention in a product or service; these circumstances are not controllable by SMEs.

On a macroeconomic level, SMEs will also feel the impact of economic downturns or trade disruptions. Take for example the Sino-US trade tensions and Brexit, which have both had a negative impact on Hong Kong’s economy, slowing down GDP growth in Q1 2019. This could especially impact export-dependent businesses or those in the shipping and manufacturing sectors.

Potential risk management solutions

In mitigating market risk, it goes without saying that monitoring the market through news and stakeholder feedback is critical. In addition, while SMEs usually lack deep pocket, they should be able to maintain a higher degree of flexibility by implement directional changes, or modifications to products and services when needed.

As a form of risk mitigation, businesses should be constantly experimenting and evolving with their products and services. They can aim to diversify, and not be dependent on a single product line or single service. This can also mean reiteration or modification of existing products based on constant customer feedback.

Businesses can also focus on building deeper interpersonal relationships with customers to protect against market changes. A strong brand nurtured through years of delivering superior product or services, will create a strong loyalty. Their customers will as a result not buy from someone else, regardless of convenience or small cost efficiencies.

Local SMEs can also take advantage of lowered trade barriers to find wider markets abroad and diversify their business. Businesses should strive to expand and move beyond their borders, rather than wait to be encroached upon. This can help them weather economic downturns as the business is not dependent on a single market to sustain itself.

2. Credit Risk

This is the most common risk facing SMEs – clients may not always pay on time and this can disrupt businesses cash flow. This is not easily resolved through loans from banks: traditional financial institutions have credit requirements that SMEs may struggle to meet.

For example, banks may require a long track record of profitability, collateral in the form of property or machinery, or fixed deposits with long maturity dates. However, pledging or owning such assets could create liquidity risk (see below), which causes businesses to mitigate one threat at the risk of another.

Potential risk management solutions

SMEs can seek trade credit insurance to shift this risk. These insurance policies cover the risk of default and non-payment of clients and are especially useful for clients who make large orders. By insuring the transaction, the company reduces tremendously the risk of bad debt. This bad debt could transform over time in plain loss, thus the need to deal with this risk. In particular, trade insurance is useful when working with a new customer, whose reliability with payments is unknown.

SMEs should as well consider alternative sources of financing.  One version of this could be factoring, in which willing investors are able to finance various businesses through a factoring platform in return for an interest rate that has a low correlation to the financial markets. Often these platforms even include trade credit insurance.

To obtain funds through a factoring platform, the business presents its accounts receivables to the factoring platform, which then provides funds equivalent to around 80 percent of the invoice value. Once the buyer—the party that owes the invoice payment—pays the platform, the latter remits the balance to the business, minus financing costs.

3. Liquidity risk

Liquidity risk occurs when cash is locked up in some parts of the business and the company is unable to pay its short-term debt obligations.

A simple illustration is a business having a large forecast from a client resulting in a high inventory of a specific product. The order is canceled due to default of the client, causing the small amount of cash the business had locked in unsold inventory. At the same time, the business needs to pay its short-term debt. The only way to move forward is to sell the product at a large discount resulting in a loss.

Another example, linked to credit risk and lower down the chain, is bad debt derived from poor credit management. If the company has a low cashflow and counted on this client payment to repay short-term debt, it will not be able to do it resulting in the business put at risk.

Potential risk management solutions

It is obvious that high cash intensive operation should be properly considered with all its implication before being made. Businesses must practice proper and strategic cash flow management. This will prevent the company to be put in the uncomfortable position of having trouble to pay its short-term debt.

Monitoring the liquidity of the company can be the start. Tools such as financial ratio comparing the short-term assets to short-term liabilities should be put into place and kept an eye on.

4. Operational risk

Operational risk pertains to the potential threats and hazards that arise in the course of doing business. It relates to the day-to-day activities and set up of processes that make the business able to deliver its product or service. Different industries have different operational risk.

For example, in a manufacturing industry two maintenances of machines are required, and the business can only afford one. Making the best decision is critical for the business’s ability to sustain its operations.

In another industry, the highest risk could be considered legal, such as violating copyright or trademark laws by accident. Furthermore, having lapses in accounting and taxes is considered an operational risk.

Potential risk management solutions

Businesses should be open to consult third party experts to mitigate some operational risk. Financial advisors, company secretary, lawyers are just some experts that would bring help in dealing with treats. For example, legal consultations are cheaper than an actual lawsuit.

Focus on mitigating risks

The rationale is simple: when businesses address credit and liquidity risks, they should start with proper cash flow and working capital management. Cash is the lifeblood of a business and is critical for the other forms of risk management.

If a company wants the resources to innovate or expand overseas, it will first need to secure the finances required. A business that has the right monetary resources is also better insulated from market and operational risk—it can be flexible, maintain all the machinery required, buy the proper amount of insurance coverage, and hire the right experts, such as lawyers or accountants, to provide crucial advice and guidance.

Post Author: Velotrade Research

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