Financial Hazards of Owning a Business

Deny Smith Tuesday, June 14, 2022 Content Leave a comment

Risk is a defined inherent component of any operating business. Developing, implementing, and monitoring a well-thought-out risk management strategy is one of the best techniques for maintaining a successful business.

Managing risk can be tricky. This is because certain types of financial hazards or risks can be proactively managed. However, other risks that may impact a business are beyond the control of the managers, who have the professional responsibility of keeping the company operational and profitable.

Understanding Financial Risk

Financial risks affect every organization. Financial risks are ‘hard-to-anticipate,’ adverse outcomes that a business faces with regard to its finances. While they are impossible to avoid altogether, they can be managed to mitigate the resulting impact when the risk hits.

Often, the best risk strategy in those instances beyond the company’s control is to –

Anticipate potential risks and vulnerabilities and
Assess the possible impacts on the business and its operations.

Consult a business attorney to ensure you prepare a proper and comprehensive response to these conceivable adverse events.

The reality is that risk, in its various forms, appears at varying levels within four broad categories. These are discussed below.

Financial Hazard #1 – Operational Risk When Owning a Business

The term Operational Risk refers to vulnerabilities that create risk through the implementation of ordinary business operations and activities. Operational Risk is a summary of a company’s potential hazards and uncertainties that may be present simply by the business’s daily activities. These risks can occur from mishaps or breakdowns in internal policies that impact a business’s systems or people, among others.

Operational risk focuses on organizational procedures and protocols. It is directly related to active decision-making policies that relate to business goals, objectives, and priorities. Operational risk is organizational-specific and not necessarily the result of external movement in a relevant industry or the entire economy.

This type of risk is also known as unsystematic risk – because the inherent risk is unique to each specific business or defined sector.

Note that risk is not always representative of a complete failure. In fact, in the business realm, the risk may result in higher operational fees or reduced production – ultimately failing to maximize profits. – but without the business being forced to shut down.

Operational Risk Types

Most companies create an operating model which poses potential risks. These vulnerabilities may include –

Legal Risks – these refer to potential financial losses that are the result of a lawsuit or other legal noncompliance. Data and cybersecurity have become a primary focus in this area.
Human Resource Risks – there are four main types of Human Resource risk categories –
- Mis-classifying one’s employees may potentially violate IRS guidelines as well as state or federal employment regulations.
- An I-9 Audit – this procedure is designed to verify the eligibility of employees working for the company. It is also conducted to make sure that employers comply with legal requirements when hiring new employees.
- Failing to Appropriately Plan for a disaster may include –
  - Physical assets in the business setting or environment.
  - Technology – which may include malware, viruses, or security breaches.
  - Personnel Risk – which may appear as errors or fraud.
  - Regulatory Risk – this is an external risk created by noncompliance with human resource legislation.
  - Legal Matters/Relationships.
Fraud Risk – this refers to business choices and decisions that may be seen as fraudulent or economically incompetent – each of which leads to a decline in a business’s integrity and reputation. One way of avoiding fraud risk is to make the employee-expense process as digitally secure as possible.

Another area that may involve risk concerns the maintenance of essential systems and equipment. If more than one pertinent area requires maintenance at the same time, a managerial decision needs to be made as to how to prioritize these dual but conflicting maintenance scheduling. The operational risk occurs because one of the two maintenance routines needs to be delayed due to a lack of funds or manpower. Ultimately, this may cause a system to fail.

Operational risk is quite challenging to measure from an objective perspective. To evaluate operational risk in a business, managers and leaders must create a historical record that may be used for comparison and forecasting for the future of the business.

Financial Hazard #2 – Market Risk When Owning a Business

Market risk refers to the potential vulnerabilities a business faces due to variations and changes in the economic marketplace in which the company operates and competes. Market risk is an example of systematic risk. This external event may impact an entire market or defined segment.

Market risk is one of the most important financial hazards to manage because the dynamics of demand and supply have such a large potential to impact a viable business. Market risks are primarily influenced by economic uncertainties.

Markets may be impacted by a variety of external events that include, in part –

A recession
Interest Rate Changes
Inflation
Terrorism
Natural Disasters
Political Turmoil, to name a few.

Market Risk Examples

Market risk is the type of risk that impacts the operations, objectives, profits, and value of a business due to changes in financial market factors.

Like most risks, market risk can take on a variety of forms –

Interest Rate Risk – refers to potential fluctuations in the overall interest rate environment – which may impact the cost of managing the business’s debt. Any debt associated with an adjustable rate will require an adjustment to its minimum/monthly payments.

Interest rates are adjusted typically by a change in an overall monetary policy by the Federal Reserve Bank – the nation’s central bank. A monetary policy’s objectives include –

Maximize employment across sectors.
Stabilize prices.
Long-term economic growth conditions.
Moderate long-term prospects of interest rates, to name a few.

Currency Risk – this refers to fluctuations of one country’s currency in relation to another country’s currency. Businesses that operate internationally will need to monitor and make adjustments to business models should unfavorable fluctuations exceed expectations and potentially create unpredicted losses or, sometimes, reduced profits.
Commodity Risk – business production is influenced by the price of commodities – this includes metals, food, and energy, among others.
Inflation Risk – inflation impacts the entire economy. It is characterized by rising prices in relation to services and products – which ultimately results in the erosion of a business’s (or consumer’s) purchasing power. Inflationary consequences include –
- Increasing prices-price increases include raw materials and other suppliers, which ultimately impact the cost of producing the product. Even service companies may be affected because the cost of rent and utilities will also be impacted.
- Demand for higher wages – inflation, with decreased purchasing power, causes current labor wages to become insufficient. The result is a necessity to increase salaries to retain a qualified workforce.
- Borrowing becomes more frequent – there is an existing relationship between interest rates and inflation, which is why interest rates are used as a primary tool to manage the overall economy.
- Potential currency fluctuations – high inflation is usually related to poor exchange rates with regard to currencies.

With the expanding digital economy, business operations have been modified in a relatively short time (like a decade or two) – which is breakneck speed. As online shopping outpaces traditional retail trade, consumer choices have created an evolving market condition that clearly differs from previous consuming generations.

The digital marketplace offers the latest example of how market risk can impact a business’s profitability.

For instance, businesses that were prepared to meet the challenges created by this recent digital shift have thrived and have even grown by jumping on and participating in the online market evolution. Businesses and organizations that were unprepared for the transition have been challenged to stay competitive.

Market risk can be managed by –

Researching customer demands and expectations appropriately.
Identifying how market risk may impact the business.
Shifting strategies to a proactive solution for the potential market risk issue.

Financial Hazard #3 – Credit Risk When Owning a Business

The definition of credit risk includes a potential loss that may result from a borrower’s inability to meet the agreed-upon loan obligations defined by a legally-enforceable contract. In fact, interest earned is the financial reward for those who typically assume credit risk in the lending arena.

While this is often a financial hazard for a lender, many businesses extend credit to their customers as a regular part of doing business. If a business client defaults on a payment, the loss to the company, depending on the size of the outstanding debt, could be significant.

Businesses can proactively manage and prepare for potential internal credit risks by ensuring their business model includes a consistent cash flow to meet their accounts payable as agreed. Businesses that begin to miss payments will likely cause suppliers to halt credit extensions with the company – some suppliers may choose to cautiously stop working with a business that is struggling financially.

Some larger businesses have teams of experts who determine the credit risks of the business’s current and potential client base. The advent of technology offers more moderate and smaller companies a way to establish their customer’s risk profiles easily and quickly. With a bit of software and legal guidance, this information can be used to create a credit risk strategy the business can use as guidance for future business decisions.

Although it is not possible to determine which client will default and why – businesses that choose to assess and proactively manage credit risk are better prepared as they have the resources and tools to overcome the turmoil created by these financial losses. As an overall rule, underwriters evaluate credit risks according to the Five C’s –

Credit History
Conditions of Loan
Capacity to Repay
Capital
Collateral

Credit risk can be managed as follows –

Establishing an application and credit check protocol for new customers or clients.
Implementing credit limits that protect the business’s cash flow. Note that the limits established will be contingent on the business size, type, and industry, to name a few.
Monitoring customer payment histories, with procedures in place to red flag late payments and other potential credit risk indicators.
Managing outstanding receivables closely, shooting for a 30 to 40-day average.
Establishing transparent and open communication channels with clients, suppliers, and customers.

Financial Hazard #4 – Liquidity Risk When Owning a Business

The term liquidity refers to a business (or individual) meeting its obligations and paying its debts without facing devastating losses.

Liquidity risk is defined by two broad categories.

The first refers to the relative ease a company may have to convert its assets to cash should a sudden, unexpected need arise. It is also present when there are not sufficient buyers or a shortage of sellers. This should be the focus of management, especially for seasonal businesses, which must be managed in accordance with leaner periods due to seasonal downturns.

The other type of liquidity risk is known as operational funding liquidity. This refers to a business’s ability to maintain a sufficient daily cash flow to meet basic business expenses just to keep the business operating and functioning. One way to manage liquidity risk effectively is to establish a well-devised cash flow management plan.

When a business cannot fund staff salaries or find the capital for more stock, the result can turn into a significant financial hazard. In the most extreme of situations, a viable business may no longer be able to sustain itself financially. Cash flow concerns should always be a priority of those managing liquidity risks in a business.

Liquidity risk can be managed as follows –

A system developed that allows management to accurately monitor/managed cash flow on a daily/weekly/monthly basis. The analysis that creates this system must include a comprehensive evaluation of all financial transactions and invoices.
Develop strategies and plans after implementing professional forecasting of scenarios that may impact the business’s cash flow and capital obligations.
Ensure payments, invoicing, and debt service are appropriately managed to meet future obligations.

Financial Hazards of Owning a Business – The Take-Away

Risk is a usual component of a business. Owning a business will include certain risks. It is simply the way a business operates. The profit generated by a business is the reward for taking the risk.

When a business is growing, different risks emerge that must be managed.

Risks can potentially lead to new opportunities, so with an educated decision and a developed financial risk strategy, there are some risks that may fit within a business’s risk tolerance.

Simply put, choosing to manage risk in any business is an essential aspect of maintaining control of a company. However, not all vulnerabilities and risks can be controlled by the management of a company. In those instances, it is best to take a cautious and prudent approach by anticipating potential issues and developing action plans should the loss occur.