Before you can even begin to think about managing financial risks, you need to understand what risk is. The word risk often makes us think about probability and chance as well as failure and loss, and these terms make sense if you are considering skydiving out of an aeroplane. However, risk as per the Australian risk’s standard can be defined as the effect of uncertainty on objectives that means risk is any deviation that may occur from what was expected. In the context of financial risk, we are considering whether changes in financial related items impact the ability of the organization to achieve its objectives. It is essential to note from this definition that the deviation from what is expected can either have positive or negative outcomes in business and life.
Financial risk management
We typically consider risk as only focusing on the negative financial impact, and we try to minimize the damage that can be caused that is we usually think of financial risk management as a valued protection exercise however it is essential to consider all financial risks and ascertain whether and how financial impacts can arise. Any decisions we make or activities we undertake to create value will attract a certain amount of risk, there are always variables and uncertainty in our business operations we, therefore, we need to consider financial risk management as being an inherent part of value creation activities. From here we know that risk is not always a bad thing, to run successful businesses we don’t always need to eliminate risks however we do need to identify risks, understand how they may impact our business and then manage those risks such that we can have the highest chance of achieving our business objectives.
There are seven categories that we use to classify and analyze financial risks, think about a small company that manufactures windows for houses and has received a large order from a customer and to fulfil this order they enter into purchase contracts with suppliers for substantial quantities of glass an aluminium the company has incurred an upfront liability that will fall due before the customer receives its order and pays, therefore, the company has a risk exposure related to having sufficient cash to pay the supplier. Invoices when they are due, this risk exposure is greater if existing assets cannot be sold quickly for money without significantly reducing the price received this is a liquidity risk and relates to having enough liquid assets that is cash to be able to make any payments that are required on financial commitments when they are due.
In a nutshell
Consider the situation where a company lens or invests money these risks associated with variations in interest rates also apply these are examples of the interest rate. The danger with floating or variable rates changes in interest rates can lead to higher or lower interest amounts even with fixed-rate loans and investments the fair value of the instrument can fluctuate if interest rates change.