FINANCIAL RISK MANAGEMENT FOR SMALL BUSINESSES

Truth be told, there is no way to run a business without financial risk, just as there is no way to make an investment and enjoy its returns without risk involvement. The only way to help mitigate or eliminate risk is by effective risk management. This article will highlight the financial risks your small business could face, why financial risk management is important to the future success of your small business, as well as effective ways to manage them.

Financial risk refers to the possibility of making financial losses in a business venture or an investment. It occurs in both small and large-scale businesses and is most times unpredictable. The first consequence of financial risk many small businesses encounter is getting into debt at the onset of their operation either as a result of limited access to credit or limited startup capital. For instance, a business starting with less than a million naira with staff to pay, technological investments to make, rent and equipment, plus marketing strategies to invest in, would need additional startup funding to prevent financial shock and losses.

Credit risk: This is as a result of clients owing the business for services or products purchased on credit, or as a result of the business borrowing loans to cater to specific needs.

Compliance risk: Compliance risk, is also known as legal risk and refers to a company’s inability to meet legal requirements and regulations. Its consequences are fines, and sometimes a temporary halt in business, which ultimately leads to loss of sales. Examples of regulations include licenses, environmental permits, income tax policies, etc.

Operational risk: This risk is not revenue-driven. It will always exist due to flaws in day-to-day functions such as imperfect business management operations, poor decision-making, and worker inefficiency. Other forms of operational risk that could incur financial losses include hiring more staff than the current financial status of the company can handle.

Reputational risk: This has financial repercussions, but cannot be predicted financially. It could arise as a result of the business going through a loss of sales due to ethical violation, a lawsuit, or issues regarding the company’s products or services. Reputational risk is even more at large in the days of advanced technology where news (whether validated or not) spreads fast on social media and the internet. Minor issues can easily be blown out of proportion once they get on the internet and eventually, the affected small business may lose important stakeholders or staff.

Market risk: This risk is caused by unfavorable changes in the market such as competition, foreign exchange rates, and consumer demand. For instance, a Nigerian business that makes investments in the United States, and has realized a 70% ROI will only have 40% returns if the Naira exchange rates fall by 30%.

Financial risk management involves identifying, analyzing, and making decisions based on either accepting or mitigating the risks of an investment. It exists so that a company can reach its goals by staying ahead of common financial risks, and making informed decisions that reduce or eliminate the impact of those risks i.e. financial loss. Financial risk management does not just stop at mitigating risk, it also requires constant monitoring of a company’s risk management strategies so that changes and improvements can be made where and when necessary.

Avoidance: This is done by completely avoiding and eliminating investments and activities that involve risk.

Retention: The complete opposite of avoidance, retention happens when a business deliberately accepts the risk that comes with investment.

Reduction: This is achieved by applying strategies for managing and reducing the severity of potential risks.

Transferring: To transfer risk means to involve a third party who will be the direct bearer of the effect of risk, through a contract, and usually for a fee.

Sharing: This means two or more parties come together to distribute the potential financial losses amongst themselves.

Credit risk: At some point, every small business may have cause to take a loan, however small. The point is to not take unnecessary loans. Managing credit risk for your small business also involves putting measures in place that ensure that your business does not suffer in the event of a client defaulting on their payment. For example, setting strict payment deadlines, tracking your cash flow at every stage of business, requesting collateral for credit services, requesting payment on delivery, and only allowing certain trusted clients to receive products and services on credit are ways in which your small businesses can manage credit risk and have a healthy cash flow.

Compliance risk: This will be effectively managed when you take proactive measures toward following necessary legal guidelines and regulations such as tax payments, environmental sanitation, etc.

Operational risk: Since this risk is caused by imperfections in factors (both human and non-human) involved in the day-to-day running of the business, to mitigate this, small businesses could dedicate themselves to hiring competent staff, and maintenance and regular inspection of necessary equipment such as machinery and automobiles, power sources, software, and network connections.

Reputational risk: A lot could happen once a company loses its reputation. To avoid this, you should have clearly defined and carefully projected business expectations, values, and mission statements to ensure that the expectations you have promised the public and their clients are being met. Reputational risk sometimes arises when a company falls short of the expectations they have promised.

In 2003, 19-year-old Elizabeth Holmes founded Theranos, A company that was supposed to be renowned for faster blood testing due to a machine capable of analyzing hundreds of elements from a few drops of blood. Theranos was promising a future in medicine, so the company received investments in billions of dollars. In 2015, it was revealed to the public that Elizabeth was no closer to creating her machine unlike what she had the public believe. The company was eventually shut down in September 2018, while Elizabeth was found guilty of fraud in 2022. Elizabeth’s company suffered reputational loss and has now left her with a net worth of $0.

Market risk: Market changes are most times unpredictable but you can prepare for them so that your business is not affected, by expanding and diversifying your products and services. This way, your business is flexible enough to adjust to whatever changes occur in the market. Hedging is a strategy that allows you to manage foreign exchange risk. It is done by a contract agreement to allow you to get a fixed exchange rate for a fixed period. This way, even when fluctuations happen in the FX market, you are unaffected.

To effectively manage financial risk, you need to be thorough in risk assessment and develop effective management strategies against them. ‘Risk’ connotes negativity; it can be beneficial when approached wisely and carefully. Calculated risks can lead to significant rewards, such as increased revenue that contributes to your business’s success. For more educative updates, visit our website at www.bizvitalsigns.com.