Managing financial risk is a basic necessity in running any business. Risk management helps to optimise earnings and to mitigate financial and reputational damage. Also, it ensures smooth execution of day to day operations.
A comprehensive risk management plan can help to anticipate future issues. Those issues could be delayed payments or defaults, along with the regular ups and downs of the business cycle. SMEs don’t need to imitate large companies in dedicating entire departments to risk management. In fact, CFOs don’t need to commit 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 the four basic forms of it:
Market risk refers to risks that come from the overall business environment itself. The circumstances causing changes in the market are not controllable by SMEs.
As an example, countries in the ASEAN region are growing more integrated. As a consequence, cheaper and more advanced products are in the market. Thus, local businesses may find their market share threatened by competitors.
Besides the emergence of new competitors, businesses will face the natural consequences of changes in the cycle. Manufacturing output may shrink as a result of political disputes. Government policy intervention in a product or service is also important factors.
SMEs will also feel the impact of economic downturns or trade disruptions or restrictions. On a macroeconomic level, companies feel the effects of economic downturns. Likewise, trade disruptions affect export-dependent businesses, such as the shipping and manufacturing sectors. For example, the Sino-US trade tensions and Brexit, have both harmed Hong Kong’s economy in Q1 2019
Market Risk Management Solutions
In mitigating market risk, it is crucial to monitor the market. News and stakeholder feedback can provide critical information. The slim structure of SMEs allows managers to have a higher degree of flexibility. Corporates can implement directional changes or modification to products and services when needed. When possible, managers need to get feedback from customers.
As a form of risk mitigation, businesses should always be experimenting and evolving their products and services. They can aim to diversify, and not be dependent on a single product line or single-service.
Businesses can also focus on building deeper interpersonal relationships with customers. Also, delivering superior products and fantastic user experience helps to create brand loyalty. Thus, it will help to expect the changes in the market and consumer’s preference. As a result, the customers will not buy from someone else regardless of convenience or small cost efficiencies.
Local SMEs can also take advantage of lowered trade barriers to find broader markets and diversify their business. Companies should strive to expand and move beyond their borders. It can help during economic downturns as the company is not dependent on a single market to sustain itself.
Credit Risk is the most common risk facing SMEs. Clients may not always pay on time and this can disrupt businesses cash flow. Unfortunately, loans through banks don’t solve the issue. Traditional financial institutions have credit requirements that SMEs may struggle to meet.
For example, banks may require a long track record of profitability. Also, they can ask for collaterals in the form of property or machinery or fixed deposits. However, pledging or owning such assets could create liquidity risk (see below). As a result, businesses are trying to mitigate one threat at the risk of another.
Credit 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. They are especially useful for clients who make large orders. By ensuring the transaction, the company reduces the risk of bad debt tremendously. This bad debt could transform over time in understandable 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. Factoring companies can finance various businesses in return for an interest rate. Often these platforms even include trade credit insurance.
Through a factoring platform, the business presents its accounts receivables to receive financing. The financing company provides funds equal to around 80 per cent of the invoice value. Once the invoice is due to payment, the buyer (the debtor) pays the platform. The financing company then remits the balance (minus the fees), to the business.
Liquidity risk occurs when cash is locked up in some parts of the business. Hence, the company is unable to pay its short-term debt obligations.
A simple illustration is a business having a significant forecast from a client resulting in a high inventory of a specific product. The order is cancelled due to default of the client, causing the small amount of cash the business had locked in unsold inventory. At the same time, the company needs to pay its short-term debt. The only way to move forward is to sell the product at a substantial 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.
Liquidity Risk Management Solutions
The high cash-intensive operation should be adequately considered with all its implication before being made. Businesses must practice proper and strategic cash flow management. It will prevent the company from being 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.
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 processes that make the business able to deliver its product or service. Different industries have different operational risk.
For example, in the 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 regarded as an operational risk.
Operational Risk Management Solutions
Businesses should be open to consulting 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.
Conclusion: Focus On Mitigating Risks
The rationale is simple. Businesses should address credit and liquidity risk with proper cash flow 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 the market and operational risk.
Working capital management helps the company to be flexible. It helps in maintaining all the machinery required. It also assures to hire the right experts, such as lawyers or accountants, to provide crucial advice and guidance.