Financial risk is the type of specific risk that encompasses the many types of risks related to a company's capital structure, financing, and the finance industry. Financial risks can be viewed with respect to the dimension they cover. In each of the four domain viz. reporting, money, cost, and compliance, let us look at different types of financial risks that are present in a business.
1. Financial reporting risks
a. Failure to adhere to statutory reporting requirements: The company may miss a reporting or a filing deadline.
b. Errors in reporting that send wrong signals to the target audiences: There may be unintended errors in the figures reported, and if these are sizable they can cause havoc.
c. Intentional wrong reporting and being caught in the act: There may be deliberate misstatements in the financial reports, and when are found out the firm can be in serious trouble.
d. Inability to establish and run a tight internal financial reporting for support to management decisions: If financial reporting is essentially oriented only to external users like shareholders market. The shareholders and the individual lenders, and no effective reporting to operating managers are available, it will result in suboptimal decisions.
e. Disregard of internal reports by operations and erroneous decisions as a result: When operating decisions are not based on relevant financial reports the risk of wrong decisions can hurt the company.
Broadly financial reporting risks occur both in the making of the reports and their use. The CFO has the difficult job of compiling the financial to present a true and fair view of the business conditions, in line with the applicable standards, the financial should also be simple enough for being understood and used by the management who may not be conversant with financial jargon. The CFO also has to foresee the impact of the reported figures on the capital market, the shareholders and the industry, and have a ready analysis that will send the correct cues.
2. Cash management risks
a. Funding risk:
Cash may not be available when needed short-term or long-term.
b. Capital structure risk:
This is the risk that the tenure of liabilities and assets are out of alignment and not matched. For instance, long-term assets may be funded with short-term liabilities.
c. Leveraging risk:
Leveraging in simple terms is the ratio of debt capital to the available equity capital. If the debt to equity ratio exceeds a certain level the business is considered to be highly levered and this is a big risk. The acceptable level of leverage depends upon many factors including the industry, the economy, and capital market conditions etc. Debt capital is less costly than equity. And has the further advantage of tax deductibility. Funding a portion of the capital required with debt keep the total cost of capital low. But dept comes with the risk that it has to be serviced regardless of whether the company makes a profit or not so debt gives the company high return, but also a high risk.
d. Liquidity risks:
Different types of liquidity risk have the treasury head should be aware of this is different from funding risk, which is the risk of a cash crunch. Here we deal with the risk of not planning liquidity levels property, not aligning liquidity to the needs of the business. In a way, this risk indicates this likelihood of fund shortage that may happen in the near future.
e. Interest rate risks:
The risk of interest rate changes that can affect the company profits and asset values.
f. Foreign exchange fluctuation risk:
The CFO of a global corporation faces two kinds of risk with foreign exchange exposure:
-The adverse movement of the exchange rate in the conversion of import and export transactions.
-The translation of year-end figures of foreign operations in local currency at exchange rates which are not favorable.
Cash management risk basically deals with the monetary liabilities and assets of the business, and the blacking of risk and return in the decision on capital structure. This class of risk is probably the must be important for a CFO to handle, as money forms the substantial bulk of his responsibility.
3. Cost management risk
The risks present in this area are the risk of losses arising from ineffective cost management. Major cost management risks include:
a. Risk of under-performing investments:
There are two kinds of investments in a business; active where a company invests in a project and runs it, and passive, where surplus funds are invested in securities and the company has no further role to play.
b. Product costing and pricing risks:
When a company launches a new product there is the risk of overpricing or under-pricing, and this is a distinct financial risk. In respect of an existing product, the key risk is wrong costing leading to incorrect price changes.
c. Revenue decision risk:
Revenue decisions refer to product mix changes, discount selling in peak season or to dear inventories and generally, actions relating to marketing and selling. the major risk here is not considering the cost figures sufficiently in detail before making decisions, and ignoring the decrease effected of a hasty decision.
For example, many companies have year-end bumper sales to reach targets. Or produce and stock up for seasonal sales. In the former case, it can happen that excess sales are made to middlemen who will not pay on time and in the letter case the off-take may not be as expected, leading to excess inventories. Both ‘these are costly risks.
d. Inventory risks:
Financial has a role in the management of inventory that cannot be exaggerated. Prompt and sensitive reporting to production and sales managers on inventory aging and slow-moving inventory is crucial. The risk is that such objective and periodic reporting may not be happening and that even when it is present, operations do not act upon it.
A less obvious risk which is far more serious is inventory valuation risk. This is the over-valuation of inventory that is restored to in some companies to boost the button line. What is forgotten by even finance managers at times is that the closing inventory of this period will automatically become the cost of sales in the next period. So if profit is shown higher in this period by overvaluing inventory, it will hit the next period profit and you are only postponing the problem.
e. Trade credit risk:
Trade credit is the credit extended to customers as a tool to improve sales. The risk in trade credit include:
-Not having a clear credit, policy or violating the policy in actual practice
-Ineffective reporting on receivables aging
-Using credit as a vital device for sales
The product should sell on its own merits and credit should only pay a supportive role. Trade credit risk does not handle well leads to bad sales, bad debts and serious working funds shortage.
f. Cost control and cost reduction risks:
Cost control is the process of keeping the cost within the budget limits, while cost reduction is the process of reducing the budget limits themselves to become more competitive. The risks faced by companies here are
-poor budgeting and fixing of standards for costs
-lack of action and attention on cost overruns
-mindless cost-cutting in the face of adverse market conditions, without realizing the long-term impact of such measures.
4. Compliance risks
A large number of statues and regulations govern business, and if the company is a multinational influence of legal observance is even wider.
Risks of failure in compliance include
a. Internal acts and omissions that amount to a violation of the law
These are by far the single most prominent risks. From the time a business decides its organization structure, it is necessary to involve legal experts and take their opinion.
b. External actions and directions against the business
Businesses also run the risk of being served notices or orders unexpectedly for alleged violations of the law.
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