Understanding Risk Management in Finance

Businesses are inevitably subject to, and need to be mindful of, a range of risk factors. These risks are not limited to financial risks. For example, risks could be at a macro-level, such as political instability, armed conflict and climate change, or at an individual company level, such as loss of reputation, key people or brand value.

Some risks, such as natural catastrophes (including pandemics), can be impossible to control and difficult to plan for and mitigate. Others, such as cyber security incidents or business interruptions, can (to some extent) be anticipated and managed. This article looks specifically at financial risk management.

What is financial risk?

Financial risk can include any type of risk associated with company financing and financial transactions. That is any risk with the potential for financial loss or financial uncertainty. According to the Chartered Institute of Management Accountants (CIMA) financial risk relates to the financial operations of an entity and includes:

• Credit risk: the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract
• Currency risk: the risk that the value of a financial instrument will fluctuate due to changes in foreign exchange rates
• Interest rate risk: the risk that changes in interest rates will affect the financial well-being of an entity
• Liquidity (or funding) risk: the risk that an entity will have difficulty realising assets or raising funds to meet their financial commitments.

To these we must also now add:

• Inflation risk: the risk that rapidly rising prices will destroy margins, undermine the value of balance sheet assets, and weaken pricing power in the market.

What is financial risk management?

Financial risk management is the process an entity undertakes to understand and manage their financial risks. It generally forms part of an integrated enterprise risk management policy that also includes operational, legal and personnel related risks. In a small company, the responsibility for financial risks (those that are likely to affect cash flows or the cost of capital) tends to fall to the business owner and senior finance team members.

Larger organisations may well employ a risk manager or a team of risk management specialists to manage enterprise risk. However, the responsibility for tracking, quantifying and mitigating financial risk tends to remain with the finance team. In recent years, many finance directors have expanded their remit and now use their data analysis expertise to oversee risk management across the business.  

Different types of financial risks

Financial risks fall into two broad categories:

1. Company specific risk (sometimes called diversifiable or unsystematic risk)

These are risks that are specific to the particular activities or situation of the company. Examples include: defaults on debt, fraud and legal challenges, particularly linked to issues around late payment or delivery and infringement of intellectual property. These are often risks that the company can identify, measure and manage through effective internal controls and other risk management techniques.

2. Market-wide or systematic risk

These are risks associated with the wider economic environment in which the company operates. Examples include: fluctuations in interest rates or exchange rates and price increases or uncertainty along the supply chain or go-to-market infrastructure.

Types of financial risk management techniques

Financial risk management techniques cover three broad areas:

1. Identification of risks. Recognising, defining and describing potential financial risks to the business. This can be achieved by project team meetings to discuss past, current and potential future risks, brainstorming, SWOT analysis and risk surveys.
2. Risk audits and analysis. Once identified, risk management requires both qualitative and quantitative analysis to reach a more detailed understanding of the issues. This is likely to include audits of how you dealt with past risks and the effectiveness of those measures.
3. Risk management project planning. This ensures the organisation has effective ways to control and mitigate risks.

Attitudes and risk tolerance levels will vary between organisations and risk managers need to work within these boundaries. However, widely used financial risk management techniques include:

• Monitoring and managing operating costs
• Controlling costs and disruption risks along the supply chain
• Reducing cash flow and earnings volatility
• Managing financing costs 
• Increasing the value of or reducing the volatility of a company’s shares.

How does risk management work in finance?

As disruption is increasing risks for almost every organisation, finance leaders can play a critical role in proactive risk management.

This falls into two broad categories:

1. Qualitative financial risk analysis

Finance leaders use their expertise and judgement to offer opinions and advice on risk matters. Those opinions are informed by:

• Probability and impact assessments to analyse the effect a risk can have on operating costs and company performance
• Risk categorisations to group risks by common causes or impact, and develop effective mitigation plans
•  Ranking risks by levels of likelihood and urgency.   

2.     Quantitative financial risk analysis

Businesses now have more financial data than ever before. But they need to analyse and convert that data into insights on risk probability, impact and mitigation. Finance teams, with their extensive skills in analysing complex data, are ideally placed to take the lead and break down internal data silos.  

To cope with risk, organisations must be able to capture, integrate and analyse data from multiple sources and touchpoints across the business.

This will enable you to:

• Spot developing risks (and opportunities) to gain competitive advantage
• Develop, and continually adjust strategies, policies and business models
• Optimise operational responses in real time.

The role of the finance team is increasingly expanding from core accountancy functions to advanced data and risk analysis. This shift is being enabled by Financial Management Systems that automate many day-to-day, repetitive finance tasks. They also give finance teams the tools and capacity to deliver more effective financial reporting, analysis and visualisation.   

A key factor for effective financial risk management is the adoption of integrated risk reporting across the organisation. Financial risk reporting needs to include both financial and non-financial metric measurement and historical and forward-looking data. Here are nine key reports, every finance function should be analysing and presenting to the board.

This article gives more details on the reports needed for effective financial risk management.

How financial risk management supports the wider business

The last two years have shown how fast the world can change. They’ve also shown how quickly businesses need to respond, adapt and – where possible – anticipate multiple risks. This is exactly why so many finance teams are now using Cloud-based Financial Management Software to help manage financial risk.

With AccountsIQ, finance teams can:

Ensure the business has a single version of the truth

When finance teams rely on Excel, sensitive financial data gets emailed around multiple departments and people make changes. You’ve no idea who did what, where or when. With AccountsIQ you can be confident you’re always using the same single source of real-time data on your group company, to set, manage and refresh key risk reporting metrics.

Comply with data security policies

Even if you have finance teams based across multiple offices or working from home, you’ll be able to implement full user access profiles and audit trails. Paperless online workflow approvals also eliminate the need for emailing documents and confusion over version control.

Provide real-time financial risk reports across the business

We have over 250 pre-built reports and a library of ready-made role-based dashboards to serve finance, the C-Suite and operational teams. They give your business access to near real-time data to inform key risk management decisions. Our Microsoft Excel Add-In can extract data for presentation and modelling, and our connector to Microsoft Power BI enables you to analyse and present analysis in multiple formats.

Poor communication is a key (and under-estimated) risk in many organisations. Not everyone is comfortable with Excel spreadsheets and financial jargon. With AccountsIQ, you can create highly visual reports that will resonate with non-finance teams and help make financial risk data accessible across your business and other stakeholders.

Run financial risk scenario models

AccountsIQ fully integrates with ProForecast, a cloud-based business forecasting tool. You can use this integrated accounting and analysis solution to manage financial risk. For example, you can build extensive scenario plans to model the impact of ‘what if’ situations, such as expanding the team, launching a new product, or revising prices.

Financial risk management: prepare for the unexpected

Risk management is an essential element of a modern finance function. It enables finance teams to develop strategies, policies and procedures to  develop resilience in the face of unexpected events. Find out more about how the reporting capabilities of AccountsIQ’s Financial Reporting Software can support your financial risk management strategy.