What is the definition of financial risk? 

Financial risk represents the likelihood of an unfavourable outcome relating to personal or business decisions. The higher the financial risk exposure, the greater the chance of losing money or becoming indebted.  

Companies and individuals should take all reasonable steps to mitigate as much financial risk as possible to prevent scenarios of loss or hardship.  

What is a financial risk? 

So, what are financial risks? Any potential future financial loss can be considered a current financial risk. The examples of loss-making scenarios are extensive, including clients or debtors not paying bills, raw material shortages, international conflict, and many more.  

Any of these examples may potentially result in a loss for the business or consumer. If the risk is severe and the worst scenario eventuates, it could be enough to put them out of business.  

Why does financial risk matter?  

Businesses and individuals must earn more money than they spend to stay afloat and assessing financial risk is integral to achieving that aim. Understanding financial risk helps to reduce the potential downsides of adverse events – if they were to occur.   

The business or individual then uses that assessment to inform decisions. As a financial risk example: a business may choose not to deal with a Politically Exposed Person (PEP) or company from a destabilised area because of a higher likelihood that it will fail to recoup the expenditure.  

Business decisions must be assessed according to your financial risk definition. Perhaps the business you’re investing in suddenly runs into supply chain issues. Maybe you’re considering extending a line of credit to a new client with less payment information on record and are unsure of their ability to make timely repayments.  

If you’re unsure of where to begin, consider conducting a third-party assessment, such as a Full Financial Risk Assessment from CreditorWatch. Incorporating two to three years of company financials, this deep dive may help flag any of these issues well ahead of time to reduce cash flow exposure.  

Why is it important to understand financial risk? 

Failure to understand financial risk may result in a higher probability of default, insolvency or bankruptcy. Without an assessment of financial risk, some people can be blinded by the potential upside of a deal – the profits or benefits. Denying the potential of a negative outcome is only looking at half the picture. Many superficially attractive opportunities fall through for various reasons, so risk assessment must remain part of the due diligence process.  

Understanding and analysing financial risk takes a pragmatic approach, creating transparency for decision-making. Tools such as DebtorLogic from CreditorWatch allow your business to conduct transactions and seek new clients while keeping a watchful eye on the risk factors associated with your Aged Trial Balance (ATB). Without this automated 24/7 monitoring, if a client’s payment behaviour starts slipping, your business may suddenly find cash flow locked in accounts receivable with bills still to pay. It only takes a couple of clients to fall away on payments, and suddenly it’s an urgent situation.