How to Manage Small Business Financial Risks

How to Guide: Small Business Financial Risk Management

Table of Contents

If you’re reading this, you most likely are not the CEO of some multimillion-dollar company with tons and tons of financial resources to hold your hand. You are a small business owner, just like us, or a freelancer, sole proprietor, or something.

In any case, you know that you know that you are much more vulnerable to the numerous risks out there on the market in many ways. And that you have do not have the kind of financial safety net the gigantic corporations have.

So, you need to be more cautious.

Being a small business or a startup (call us whatever you want), we know this too! That’s why we decided to put this article together. Here we’ll tell you about the most common financial risks the small businesses face, some from our own experience and some based on the statistic.

Oh! And yes, we will also present some ways for you to avoid these financial risks. But first…

What is financial risk management, and why should you care?

You know what a risk is. You encounter it every single day in various forms – walking bare feet on the wet bathroom floor, or crossing the street like crazy in the middle of the traffic, or not asking your wife how her day was. Whatever works for you.

But the business risks or, more specifically, financial risks are slightly different.

Why? Because it’s not always so obvious. And usually, there a whole business at stake when it comes to some financial risks.

Unfortunately, as most people discover sooner rather than later, the financial world is rife with different risk levels. So, we humans invented this practice of financial risk management, which is basically a glorified name for “the art of getting ready and dealing with financial problems.”

In short, anything that relates to hindering money flowing in and out of business is a financial risk.

And as the recent pandemic and economic shutdown have shown, it’s important to prepare for both expected risks and surprises. So, it’s more relevant than ever.

In a small business, the business owner and senior managers are responsible for risk management. It’s only when the business grows to include multiple departments and activities you may wish to bring in a dedicated professional.

Until then, it’s on your shoulders, and here’s the list for you.

Four major financial risks of small businesses

Here are the four most common financial risks your business might face, or rather the four categories of financial risks:

Market Risk

As the name implies, market risk is any risk that comes out of the marketplace in which your business operates. For example, if you are a brick-and-mortar clothing store, customers’ increasing tendency to shop online would be a market risk. Companies that adapt to serve the online crowd have a better chance of surviving than businesses that stick to the offline business model.

More generally, and whatever sector you’re in, every business runs the risk of being outpaced by competitors. If you don’t keep up with consumer trends and pricing demands, you’re likely to lose market share.

Credit Risk

Credit Risk applies to anyone. Suppose you fail to pay the insurance premium. In that case, it’s credit risk. Or if the insurance company does not cover your risk, it’s credit risk.

Basically, it is the possibility that you’ll lose money because someone fails to perform according to the terms of a contract. For example, if you deliver goods to customers on 30-day payment terms and the customer does not pay the invoice on time (or at all), then you have suffered a credit risk. Businesses must retain sufficient cash reserves to cover their accounts payable, or they are going to experience serious cash flow problems.

What you need to do is to always have a line of credit available during times of financial stress. Just as with personal finances, a business should have an emergency nest egg—ideally with six months of expenses saved—or an accessible line of credit. When a high-risk situation such as Covid-19 strikes, this accessible cash could be what bridges the gap between staying open or closing your doors for good.

Another way to protect yourself is to purchase insurance, hold assets as collateral or have the debt guaranteed by a third party. Some methods businesses use to neutralize credit risk arising from non-payment of client dues is to request for advance payments, payment on delivery before handover of goods, or to not provide any lines of credit until a relationship has been established.

Want to learn when it’s okay to take a loan (one of the major sources of credit risk) for a small business? Here’s the article where we cover Top 7 Reasons for Why Businesses Should Take a Loan.

Liquidity Risk

Also known as funding risk, this category covers all the risks you encounter when trying to sell assets or raise funds. If something is standing in your way of raising cash fast, then it’s classified as liquidity risk. A seasonal business, for example, might experience significant cash flow shortages in the off-season. Do you have enough cash put aside to meet the potential liquidity risk? How quickly can you dispose of old inventory or assets to get the cash you need to keep the lights on?

Liquidity risk also includes currency risk and interest rate risk. What would happen to your cash flows if the exchange rate or interest rates were to suddenly change?

Operational Risk

Sometimes businesses are so worried about external issues that they cannot come up with a well-defined financial risk management plan to take care of potential in-house operational issues. These risks could include failures of your day-to-day operations, technical failures, or staffing issues. Although this type of risk might seem minimal compared to other risks, they most certainly are not.

Operational risk is a catch-all term that covers all the other risks a business might encounter in its daily operations. Staff turnover, theft, fraud, lawsuits, unrealistic financial projections, poor budgeting, and inaccurate marketing plans can all pose a risk to your bottom line if they are not anticipated and handled correctly.

That’s it. You are now aware of all four major types of financial risks small businesses might face.

Conclusion

Before we end, let us say one more thing.

Do not ignore financial risk management just because your company is too small to have a dedicated team for it. As a small business owner, you are the heart of your company, and together with your employees, you make up the body of the business. And just as no person is too small for a stroke, so is no company too tiny for various types of financial crises.

It definitely is not easy, but facing it head-on and armed with the required knowledge can help ease the process. We actually have a comprehensive guide to the basics of small business financial management. So, be sure to take a look.

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