A financial risk management plan is a comprehensive strategy that outlines how an organization identifies, assesses, and mitigates potential financial risks to minimize losses and optimize financial performance.
And, as you might imagine, having one is crucial — in fact, nearly half of all businesses fail by the fifth year due to cash flow issues.
The reality is that even with sound operations, a solid project management team, and historically high revenues, you don’t know what event might pop in to throw your business off track.
The solution? Identify risks your business faces and plan so you’re ready. When you understand them, you can create a risk management plan and stay one step ahead of the unexpected.
What is risk management?
Risk management refers to the process of identifying, assessing, and managing potential risks that could impact your business negatively.
Some common risks are:
- Financial risks, which include credit, market, liquidity, and operational risks
- Operational risks, which include processes, systems, human error (like equipment failures, errors in data entry), and supply chain disruptions
- Compliance risks — which might refer to legal and regulatory risks — like non-compliance with laws and regulations related to data privacy, employment, and environmental issues
- Reputational risks, which might include the public’s perception of your business like negative media coverage or customer complaints
- Environmental risks, which may result from natural disasters
One of the most common types of risks that businesses face is financial risk. Financial risks are a sector of risk management as a whole — but the risk that fall under them are common and detrimental.
What is financial risk management?
Financial risk management is a specific type of risk management that focuses on identifying, assessing, and mitigating financial risks, including credit, market, liquidity, and operational risks. The primary goal of financial risk management is to protect a business’s financial resources — like working capital, cash flow, and assets — and help minimize the impact of a loss.
Financial risks vs. project risks
Financial risks like changes in interest rates, currency exchange rates, or commodity prices can harm a company's financial performance. These risks can impact a company’s money, how much they earn, and how much they spend.
Project risks can affect how well a specific project goes, like delays, spending too much money, technical issues, or insufficient resources. Project risks may not necessarily harm a company’s overall financial performance, but they can hurt the success of a particular project.
Common types of financial risks
Some of the most common types of financial risks include:
- Credit risk: Credit risk is the risk of financial loss that arises from the failure of a borrower to meet their debt obligations. This can include the risk of default on loans, bonds, or other debt instruments.
- Market risk: Market risk is the risk of financial loss that arises from changes in market conditions, such as fluctuations in interest rates, exchange rates, or stock prices. Market risk can impact investments in stocks, bonds, and other financial instruments.
- Liquidity risk: Liquidity risk is the risk of financial loss that arises from a business’s inability to meet its short-term financial obligations. This can occur when a company does not have sufficient cash reserves to cover its short-term liabilities.
- Operational risk: Operational risk is the risk of financial loss that arises from operational failures, such as system failures, employee errors, or supply chain disruptions. Operational risk can impact a company’s profitability and reputation.
- Reputational risk: Reputational risk is the risk of financial loss that arises from damage to a company’s reputation. This can occur due to negative media coverage, customer complaints, or other factors that impact public perception of the company.
- Systemic risk: Systemic risk is the risk of financial loss that arises from a breakdown in the broader financial system. This can occur due to economic recessions, market crashes, or political instability.
But the actual key to risk mitigation is creating a financial risk management plan. A risk management plan can help reduce the harsh impact of these adverse outcomes to ensure your business is better equipped to handle unexpected challenges.
Financial risk management plan process
Think of a financial risk management plan as a roadmap that helps you navigate the uncertain terrain of financial risks. Just like how a GPS gives you step-by-step directions to your destination, a financial risk management plan outlines the steps you need to take to identify, assess, and mitigate financial risks that could impact your business.
A financial risk management plan entails a few steps but starts with identifying potential risks that might currently or in the future affect your finances. Once you’ve identified these risks, you need to assess the type of impact they’ll have on your finances. Then, develop strategies that will help mitigate those risks.
Here’s a breakdown of the financial risk management process.
Step #1: Identify financial risks that might affect your business
The first step in the financial risk management process is to identify your business's risks. This involves comprehensively reviewing your operations, financial statements, and market conditions to identify potential risks.
But this sounds easier said than done. When you’re trying to identify possible risks, try to look for trends in your financial statements (is revenue declining, or is debt increasing?), conduct a SWOT risk analysis (strengths, weaknesses, opportunities, and threats), and consult with financial professionals that might have valuable insight.
Step #2: Analyze those risks to determine their impact
Once you’ve made risk identification, the next step is to analyze them in detail. This involves assessing each risk’s likelihood and potential impact and determining the appropriate level of response.
You might choose to use a risk assessment matrix for this step. The matrix typically consists of a grid with two axes: likelihood and impact. Likelihood refers to the probability of a risk occurring, while impact refers to the potential consequences of the risk if it were to occur. The likelihood and impact can be rated using a numeric scale (1-5 or 1-10) or descriptive terms (low, medium, or high).
Each risk is assessed and assigned a score based on its likelihood and impact in a risk assessment matrix. The resulting scores prioritize risks for further evaluation and risk management planning.
You could consider other options — like scenario analysis, stress testing, qualitative and quantitative impact analysis, and historical analysis. No single method will provide all the information you’re looking for; instead, a combination might be necessary to assess risks against your business accurately. If you’re not sure where to start, be sure to consult with an expert who can analyze your financials for risks.
Step #3: Develop risk management strategies to help mitigate
Some risks are more pressing than others, so you’ll first want to prioritize based on each risk’s potential impact. When it comes to developing actual strategies, you can choose from a handful that many businesses and companies utilize, such as:
- Hedging: Hedging involves taking a position in the market opposite to a current position. For example, if you own a stock that you are concerned may decrease in value, you could use a hedging strategy to protect against losses by taking a short position in the same stock or a related security. Hedging can help reduce the potential losses from a particular risk.
- Insurance: This involves transferring the risk to an insurance company in exchange for a premium. Insurance can provide financial protection against various risks, such as property damage, liability, or loss of income. The insurance company assumes the risk in exchange for the premium, and if a loss occurs, the insurance company pays out a claim.
- Diversification: Spread your investments across a variety of different assets or sectors. By diversifying your investments, you can reduce exposure to any single risk or asset. For example, instead of investing all your money in a single investment, you could invest in a diversified portfolio of stocks, bonds, and other assets.
- Contingency planning: Prepare for potential risks by developing a plan of action in case the risk occurs. This may involve identifying alternative suppliers or vendors, establishing emergency funds, or developing a crisis communication plan. Contingency planning can help you prepare for unexpected events and minimize the impact of potential risks.
Each risk management technique has its own good and bad points, and the one you choose will depend on what risks you’re dealing with. But, if you combine these techniques, you can create a strong plan to manage risks and keep your money safe. This can help you reach your financial goals without worrying about surprises.
Step #4: Implement the risk management plan in real-time
So, you know what to do – but how do you do it? Depending on what your strategies are, you’ll obviously take different steps. But generally speaking, here’s what you’ll want to do:
- Assign responsibilities: Figure out who’s going to do what. Pick team members responsible for making the risk management plan happen and give each person a specific job.
- Establish timelines: Make a clear schedule and timeline. Decide when each part of the risk management plan needs to happen and set clear deadlines.
- Allocate resources: Figure out what you need. Decide what kinds of resources you’ll need to make the plan work — this could be money, people, or technology.
- Communicate the plan: Communicate the risk management plan to all relevant stakeholders, including employees, partners, and suppliers. Tell everyone who needs to know about the risk management plan and make sure they understand the course of action.
After implementation, monitor (and update, as necessary) your plan. Sit down and analyze your financial risk management plan at least once yearly or whenever significant business, market, or industry changes occur.
Risk management plan example
Let’s say you run an e-commerce business selling candles, lotions, and soaps. You’ve identified several potential financial risks you need to assess: Changes in customer preference, fluctuations in the cost of raw materials and shipping fees, and cash flow problems due to delayed customer payments.
To better understand how these issues might affect your business, you ask: “How likely are these changes in preference and cost in raw materials going to affect me? What are some early signs I could recognize? Can I prioritize any risks that need my attention right now?”
After consulting with a financial advisor, you decide to implement a few strategies by hedging against rising costs in raw materials by locking in prices with suppliers, diversifying the product line to appeal to different customers, and implementing a contingency plan to manage cash flow.
If you have any employees, you’ll inform them of this new plan now and assign specific tasks to each one. After implementation, you’ll continuously monitor and review your risk management plan and make necessary adjustments to stay one step ahead.
Four financial risk management tips for small businesses
Financial risk is a big deal because you could be forced to close if you’re not prepared to mitigate risks. But there are many strategies you can use to manage risk and increase resilience. Here are four ways you can stay one step ahead when it comes to mitigating risks:
- Network with other business owners: Be open to your peers’ knowledge, support, and help. Please read about the stories of other small businesses in your niche to learn about their strategies for risk identification, mitigation, and creating success.
- Look to the future: Don’t rely on historical trends and past laurels. Instead, focus on the future: for example, what you expect your cash flow to be in six months, your sales to be two years from now, and your liabilities three months from now. When you focus on what you expect to happen tomorrow, you’re more likely to take steps to make that future happen.
- Budget for the unexpected: Make decisions based on the assumption you always need to keep cash in the bank to cover unexpected expenses. Creating a rainy day fund for your business is one of the most straightforward and innovative risk mitigation strategies.
- Be expense-management obsessed: Sometimes, it’s hard to understand your financial position, making it challenging to plan for financial risk. That’s why tracking expenses and budgeting your risk management team very diligently is essential.
And when you use automation software, you know your numbers are accurate, and you can quickly generate financial statements. You can see where you are and make decisions based on data instead of assumptions.
Plan confidently with BILL
Part of creating any risk management plan is knowing where your expenses and accounts payable are at right now. With BILL's automated AP platform, you can have the answers you need at your fingertips, and plan your investments with confidence. Learn more here.
