Few choices in life come with zero risks—and running a small business is no different. In our work supporting hundreds of thousands of small businesses of all sizes and types, we’ve seen close up how financial risks in business can impact a company’s ability to operate efficiently—and even threaten long-term viability.
Learn more about some of the most common financial risks faced by small business owners, how to minimize those risks, and protect your company’s future success.
Highlights
- Small business financial risks include anything that increases a company’s likelihood of losing money.
- Risk isn’t always a bad thing—many risks come with the possibility of a reward, and sometimes taking a strategic risk is the right move.
- Every business will face a certain amount of financial risk, so managing risk is an important skill for any small business owner.
What is financial risk?
Financial risk is anything that increases the chances that a company will lose money due to uncertain future events.
All businesses face uncertainty—industry trends and the economy at large can have major impacts on small businesses, and they are often difficult to predict. If you want your company to achieve long-term success, you have to know how to manage these financial risks.
Financial risk vs. business risk
Let’s clear up some basic definitions.
A financial risk is a risk related to a company’s ability to make enough money to pay off its debts. The more debt financing a company has, the higher its financial risk, because they are more likely to have trouble meeting their financial obligations. There are many ways to determine a company’s financial risk, including examining the debt-to-equity ratio.
A business risk relates to whether a company will be able to afford its operating expenses—such as payroll, inventory, and rent—and also make a profit.
However, for the purposes of this post, we’re referring to all risks that can affect a company’s overall finances as “financial risk.” Basically, if it can affect your bottom line, we want you to know about it.
What are the financial risks faced by small businesses?
Every type of risk presents its own set of challenges and requires different strategies to manage effectively.
Some of the most common types of financial risks include:
- Credit risk
- Market risk
- Interest rate risk
- Operational risk
- Liquidity risk
5 common types of financial risk—and how to manage them
1. Credit risk
Credit risk occurs when a business such as a financial institution or a supplier offers a line of credit to a small business. When this happens, there is always a danger that the small business might not be able to repay these debts on time. They would then incur fees and might have difficulty obtaining more credit in the future, because they have a higher default risk. Some suppliers may even refuse to do business with a company that can’t pay its debts.
How to manage this financial risk
Many small businesses will need credit at some point, and it’s not something that you necessarily need to avoid. Still, if you find that you are able to cover your costs through income alone, you might not need to take out a line of credit or go into debt. A healthy cash flow might be enough to keep you afloat.
You also don’t want to borrow more than you actually need—there’s no need to max out a line of credit every time you get the opportunity.
It’s also a good idea to keep an eye on your business credit score, and work to improve it over time. This means paying bills on time, every time, and making sure your business never has any collections or liens.
2. Market risk
This is a general risk of changes in the market, such as changes in competition, consumer demand, or industry regulations. Market risk is largely outside of your control—for example, a supply chain disruption could affect your ability to provide certain products.
Market changes are difficult to predict and even harder to control for, but there are a few ways to help prepare for them.
How to manage this financial risk
Managing business risk can be a complicated process, and you will never be able to reduce the risk to zero. However, a good way to start is by diversifying revenue streams—if you only have one product or service, you are more likely to be subject to different changes in the market. If you expand a bit, you have more flexibility.
It’s also important to take business forecasting seriously. This process uses present and historical data to determine economic conditions and prepare for changes—a smart idea when the market is always changing.
It’s also important to have contingency plans in place. You can’t predict everything, but if you are offering a unique product or service, it’s a good idea to know how you’ll pivot once competitors enter your space. What will you do to continue to stand out?
3. Interest rate risk
For small businesses with investments, interest rate risk is an important concern. This is the risk that changes in interest rates will affect investment returns. As interest rates rise and fall, they can affect the value of bonds or other fixed-income investments.
Interest rate risk can also affect businesses that depend on loans or credit. If interest rates increase, the cost of borrowing money will increase, making it more difficult for a business to repay its debt.
How to manage this financial risk
In order to manage this risk, it’s a good idea to refinance loans when interest rates are low. You should also maintain plenty of cash reserves, and keep a close eye on interest rates as they change.
Also, if you choose to invest in bonds, try to diversify your bond maturities. This will ensure that as interest rates fluctuate, you are able to either invest in more bonds (as rates go up) or invest elsewhere (as rates go down).
4. Operational risk
This includes the risk of financial loss due to factors such as system failures, fraud, safety violations, harmful business practices, and other internal factors. Poor decision making, inefficient management, lack of planning, and even simple human errors—like an incorrectly entered number in a spreadsheet—within a company can all contribute to this kind of financial risk.
Essentially, people make mistakes—and this can cause a lot of financial risk for your business.
How to manage this financial risk
Managing these risks will look different for every industry and every business, because your particular risks are likely unique. However, there are a few best practices you can follow to help manage operational risk.
First, make sure that the processes you have in place are actually effective. This can include the processes that you use to check for safety, accuracy, and product or service consistency. These processes need to be documented, followed, and revisited from time to time to make sure they are still the best way to achieve your goals.
Next, keep your internal systems up to date. Software is becoming more integral to doing business, but it can open you up to certain risks. Always make sure to install updates on any software you’re using to make sure you have the latest bug fixes. You can also follow procedures to prevent fraud, such as monitoring employee spending with expense management software.
Automating your financial processes can also significantly reduce human error. For example, software that automates expense reports will not only streamline your processes, but also give you more accurate results.
5. Liquidity risk
There is often a risk that a company may not have enough cash or liquid assets to cover its financial obligations. If you run out of cash, you might not be able to pay bills, salaries, or other essential expenses. Small businesses are especially vulnerable to this financial risk, because they often have limited resources and a relatively small number of customers.
How to manage this financial risk
Cash flow management can help reduce this risk, as well as carefully monitoring financial statements. Knowing where your money is going helps you better prepare for potential emergencies. It’s also helpful to have access to credit to cover short-term needs if necessary.
Financial risk isn’t always negative
These financial risk examples don’t cover all the different types of risk small businesses can face, because almost every decision a company makes includes some amount of risk. That might sound a little scary, but it doesn’t have to be.
In fact, sometimes taking a risk can be a good thing. For example, taking a calculated risk— such as investing in new products or expanding to new locations—will involve a level of risk, but could also lead to increased revenue. Or taking out a loan may put you at a slight risk of defaulting, but with financial risk management, you are much more likely to make your payments on time.
Risk isn’t something to avoid entirely—it’s something to be smart about and manage carefully.
Mitigate financial risk by spending smarter
Staying on top of your finances is key to minimizing financial risks, and spend management software can help you in more ways than one. BILL Spend & Expense can increase visibility into spending, track expenses in real time, and generate automatic expense reports. This means it’s easier than ever to take control of your cash flow to help mitigate common financial risks.
Try a BILL demo today and see how our corporate charge card can simplify your finances.