Risk management: Why it’s important in finance

In today's complex and rapidly changing business landscape, organisations must navigate obstacles such as geopolitical conflicts, supply chain disruptions, inflation, and cyber threats to thrive. These challenges loom over businesses posing risks capable of causing severe financial damage. Dun & Bradstreet's Global Business Risk Report Q3 2023 further reinforces this, highlighting the situation where these risks confronting businesses remain elevated, with some worsening and new ones emerging.

Effective risk management serves as the essential tool to shield your business against these risks and their financial implications.

Through this blog, understand different financial risks a business may encounter, what financial risk management entails, and the various techniques and tools for effective risk management.

What is risk management in finance?

In finance, risk management means proactively detecting, analysing, and mitigating current and potential risks that could negatively impact the financial health and objectives of the company.

Financial risk management process usually begins with identification and classification of risks. The next step is their assessment to determine the likelihood of their occurrence and financial impact. After assessment, appropriate risk mitigation and control strategies are employed. Monitoring and reviewing risk strategies and their effectiveness are continuous processes, and new risks are constantly looked for. Ensuring compliance with relevant regulations and reporting risk management activities also form an essential part of the process.

Importance of risk management in finance

A strong risk management strategy can yield several benefits for a business, such as:

1. Prevents financial losses

Avoiding or reducing potential financial losses is the primary purpose of risk management. By identifying risks early on, it helps take proactive measures to mitigate and reduce the impact of adverse events such as market downturns, credit defaults, or operational failures.

2. Improves financial stability

Financial risk management safeguards capital and assets from losses, maintaining financial stability, enhancing profitability, and ensuring the long-term viability of the organisation.

3. Aids decision-making

It provides valuable insights into potential risks associated with various investment opportunities or financial transactions, enabling informed decision-making by weighing potential returns against the risks involved.

4. Helps adapting to market changes

By devising contingency plans, it helps organisations navigate uncertainties, manage market fluctuations, and leverage opportunities that arise in the dynamic business landscape.

5. Maintaining compliance and reputation

A comprehensive risk management system goes beyond just financial risks. It helps organisations comply with legal requirements and protects them from reputational damage caused by various financial or non-financial issues. This, in turn, maintains stakeholder confidence and credibility.

Different types of financial risks

It is important for businesses to understand the kind of risks they might be exposed to, as even the ambiguous ones can be extremely consequential. Here are some types finance teams should be familiar with:

1. Operational risk

These risks encompass scenarios where financial losses may occur due to errors, failures, or unforeseen events hindering daily operations and processes. For example, a malfunction in the assembly line could halt manufacturing, resulting in delayed production and financial losses.

2. Credit risk

This represents the risk associated with customers or borrowers failing to meet payment obligations, for example, when scheduled payments are overlooked. Effective credit management is indispensable in managing and reducing exposure to these risks.

3. Market risk

It is the risk of a business getting impacted by changes in the market. For instance, sales of luxury goods decline during a recession. Diversifying products and clientele can be an effective way to reduce market risk. Inventory management strategies also play a role in managing it.

4. Legal risk

It refers to the possibility of legal repercussions and associated financial losses. For instance, a company could face penalties for breaching financial regulations due to non-compliance. Minimising liability is crucial to mitigate legal danger. Cloud technology has proven to be an effective way of improving compliance.

Financial risk management techniques

There are different techniques that can be employed to effectively manages risks, such as:

Avoidance

This method involves completely avoiding the risk by staying away from the activities or situations that could lead to risks and choosing the safest option. For example, a company can avoid the risk of delayed payments by avoiding lending trade credit to a business with low credit score.

Retention

A retention strategy involves accepting the responsibility for risks and being prepared to bear the consequences if they occur. For instance, a company might decide against insuring an asset, upon determining that the cost of insurance is higher than the potential loss.

Risk reduction

This technique involves adopting ways to minimise the probability and impact of a risk. Diversifying suppliers to reduce dependency on a single source or implementing strict quality control measures in manufacturing to reduce the likelihood of defects are examples of this strategy.

Risk transfer

In this method, the economic burdens associated with the risk are passed on to an external entity. A classic example of this practice is evident when securing insurance for assets, wherein the insurer undertakes the risks of potential loss or theft for a designated fee.

Risk sharing

In this method, the potential losses associated with a risk are shared with another party. This can be done through outsourcing or contracts with suppliers or partners.

How finance teams factor into risk management

Providing essential data and performing specific tasks to identify, assess and mitigate risks, finance teams play a vital role in effectively managing risks within an organisation. Let's understand how finance teams factor into risk management and their specific contributions:

1. Risk identification and assessment

Working closely with other departments, finance teams utilise available data to scrutinise financial statements, market indicators, and other essential factors, pinpointing potential risks, including liquidity, credit, market, operational, and regulatory aspects, that could impact the organisation's financial stability.

2. Risk modelling and scenario analysis

By employing data analytics tools and statistical models, finance teams construct risk models and conduct scenario analysis. Through stress tests and sensitivity assessments, they gauge the potential impact of different risk events on the organisation's financial health. This process quantifies risks, facilitates an understanding of possible outcomes, and aids in developing contingency plans.

3. Compliance and regulatory requirements

It is a critical role for finance leaders to ensure compliance with risk-related regulations. They monitor regulatory changes and implement necessary controls to mitigate compliance risks. Collaborating with legal and compliance departments, financial management systems can ensure that risk management practices align with legal obligations and regulatory requirements.

4. Internal controls and auditing

The team can establish and maintain internal controls to protect the organisation against risks. They design and implement control procedures that mitigate identified risks and monitor their effectiveness. Additionally, finance teams work with internal and external auditors during risk audits to evaluate the sufficiency and effectiveness of risk management processes.

5. Risk mitigation and monitoring

Finance teams play a crucial role in crafting and executing risk mitigation plans. Collaborating with various departments, they enforce measures like insurance coverage, hedging tactics, diversified investments, and contingency plans. Moreover, they vigilantly track risk signals and key performance metrics to swiftly detect and manage evolving risks.

In conclusion, the finance department is essential for risk management, offering timely financial reporting, in-depth risk analysis, and strong internal controls. Their skill in data analysis and financial insights assists decision-makers in protecting the organisation's financial stability and resilience.

The right tools for risk management

There are many technologies that companies can use for managing financial risk. Here are five tools that can support organisational risk management:

Enterprise risk management (ERM) software

Enterprise risk management is a holistic approach to identify, assess and mitigate risks. ERMs, also known as risk management information systems, help finance teams identify and analyse a diverse array of threats while offering visibility into potential risk areas for proactive measures.

ERM platforms may possess advanced artificial intelligence capabilities, such as data analytics, risk aggregation automation, risk assessment and simulation, natural language processing, and risk reporting.

While ERM tools are generally regarded as a necessity for many organisations, they are often complemented by more specialised software for managing specific areas. Robotics Process Automation (RPA) is among the AI capabilities these systems offer to streamline labour-intensive and repetitive tasks.

Governance, risk, and compliance (GRC)

GRC stands for governance, risk management and compliance. It often is a complicated procedure and can be controlled by specialised software that combines several solutions into a single overarching framework. This can aid businesses in risk identification and assessment, resource sharing among team members, and the prevention of internal fraud.

Organisations may implement their GRC strategies more successfully with the aid of a comprehensive approach. This entails employing a common framework (rather than disparately housed data silos) and enabling financial risk managers (FRMs) to approach risk identification and assessment with more knowledge.

GRC technology adoption can take some time, but it can also have a big positive impact on efficiency.

Automated credit scoring technology

Credit-granting finance departments can gain from automated credit scoring technology. Automated credit scoring technology can assist FRMs in reducing the risk of payback default and maximising the economic performance of their organisations. Use cases for this technology include credit card issuance, personal loans, microloans, and consumer credit initiatives like buy-now-pay-later.

Credit scoring automation can examine ongoing customer history updates and draw insights about applicants for future more precise, informed decision-making using machine learning in the form of customer behaviour analytics.

Cybersecurity

Every organisation's approach to managing technology risk must include cybersecurity, thus FRMs must become more knowledgeable about cybersecurity tools and procedures.

There are many new opportunities for organisations due to digitisation and changing market developments. But because hackers and fraudsters are always developing new, sophisticated ways to conduct data breaches, commit financial fraud, and harm businesses with cyberattacks, it has also created a completely new profile of risk.

To develop strategic defence mechanisms against the danger of malware, cybercrime, and more broadly, to examine all kinds of cyber vulnerabilities, the leading cybersecurity solutions frequently include cutting-edge AI and machine learning capabilities.

Cloud computing

The transition from on-premise software infrastructure to scalable Cloud computing is accelerating. Cloud providers have addressed corporate concerns over fraud risks, such as data breaches and security threats. FRMs increasingly recognise that continuing with on-premise infrastructure may open their organisation up to more risk.

How OneAdvanced Financials can help you improve your risk management

Financials, our Cloud-based accounting software provides ongoing maintenance and security updates, scales with your organisation's needs, and evolves with everchanging tech advancements. By adopting Cloud computing as a prominent tool, businesses can shift away from the perils of outdated systems and have greater control over their financial outcomes.

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