Financial Risk: Definition, Types & Examples (2024)

KEY TAKEAWAYS

• Financial risk affects several groups including individuals, businesses, markets, and governments.
• It’s the potential for loss or negative outcomes due to situations that may or may not be within your control.
• Some financial risks are taken because the potential for additional profit or opportunity outweighs the risk associated with the decision.

What Is Financial Risk?

Financial risk refers to the potential for losing money on an investment or having a negative business outcome. There are several types of risks. Some potential risks can be controlled and others are factors beyond your control. You may take even some welcomed financial risks because they hold the possibility for new opportunities and growth.

Financial risk also affects different groups of people in different ways. Typically when discussing financial risk, it can affect multiple levels of the economy.

• Individuals
• Corporations
• Governments
• Market

Within each of these areas, different forms of financial risk can be experienced along with advantages and disadvantages for each. In this article, we’ll cover these topics as well as the pros and cons.

Types of Financial Risks

Multiple forms of financial risk can be experienced. They include:

• Credit Risk
• Funding Liquidity Risk
• Asset-Backed Risk
• Foreign Investment Risk
• Profitability Risk
• Third-Party Risk
• Regulatory Risk
• Economic Risk

Liquidity, asset-backed, and foreign investment risk are all concerns that have the potential to impact the profitability of a business. While there are many forms of financial risks, it’s an expected part of doing business and existing in a market or economy.

Credit Risk

This type of risk is also known as default risk or borrower’s risk. It’s the level of danger associated with borrowing money and having too much debt. This type of risk arises when a borrower loses the ability to meet their payment obligations on a loan, credit card, or other forms of debt.

This is a risk for creditors since the disruption in payments affects their income projections. This also affects the borrower since the defaulted credit account will negatively affect their credit score, potentially lead to repossession of collateralized assets, and reduce their chances of qualifying for future credit accounts.

Credit risk can also be applied to investors. Credit risk to investors means losing income on the missed principal and interest payments from the money they’ve loaned. It’s common for credit risk to be used to describe an investor’s uncertainty in receiving the return on their investment.

Liquidity Risk

Two forms of liquidity risk may raise concerns for investors. The first type is a cash flow liquidity risk where reduced cash flow impacts a business’s ability to access its capital to pay debts or handle daily operations. This can lead to defaulting on payment obligations and may lead to a bankrupt company.

The second type is market liquidity risk which is the possibility that demand doesn’t meet supply for the securities and assets that the business possesses. In a more volatile market, certain securities or assets might be more difficult to sell due to a lack of buyers.

Asset-Backed Risk

Asset-backed risk refers to the possibility that the underlying securities for asset-backed securities will lose value and cause those holdings to lose value in the process. A common example of this is when a lender issues a 10-year loan to a consumer with the expectation of receiving 10 years’ worth of interest and principal payments. If the customer paid off their loan within 5 years instead of the full loan term, the lender receives much less interest than they had planned.

Foreign Investment Risk

These types of risks concern changes made by a government. International governments issue bonds and notes to fund their country’s interests. The chance of defaulting on those debts can create foreign investment risk. It can result from–

• Political turmoil
• Loss of control over monetary policy
• Uncontrolled inflation
• Debt issues
• Overly-aggressive taxation

These risks are minimal in stabilized countries but in other countries with a record of defaulting on debts, the risks investors face might be much greater.

Profitability Risk

There’s a level of risk in running a successful business and a lot of it is in making sure the business is profitable. This requires cash flow management to ensure that obligations and capital needs are met. Even if your business doesn’t rely heavily on debt to fund daily operations, there’s still a basic need for successful companies to have revenues that outweigh expenses.

Third-Party Risk

When working with a third-party supplier or service provider, there may be disruptions or unexpected events that impact your ability to continue running the business as usual. This makes the practice of outsourcing particularly risky since it requires your business to rely on the practices of another individual company where you have a lack of controls over its processes and policies.

Regulatory Risk

There is a lengthy list of financial regulations that a business and investors must meet to comply with the law. Not meeting some of these regulations may result in fines, time-consuming audits, or a loss of skilled labor.

Economic Risk

Doing business in other countries can impact your business. The conditions in the other country such as social or political unrest, climate risk drivers, and fluctuations in exchange rates hold the possibility for your business or investments to lose money.

Pros of Financial Risk

Risk isn’t always a bad thing. Taking a risk can result in larger future profits under the right guidance. The advantages of taking financial risks include:

• The ability to assess the risk vs reward.
• It can be identified and mitigated through a risk management strategy, analysis tools, and calculations.
• Promotes an educated and informed business decision-making process.

Cons of Financial Risk

The disadvantages to taking on financial risk are:

• It’s not always controllable. It can stem from unpredictable circ*mstances.
• Risk can spread from a handful of companies and affect a whole industry, or an entire marketplace.
• Some risks are insurmountable or require a lot of work to overcome.

Tools to Control Financial Risk

Several tools are available to help calculate financial risk. These tools enable businesses and individuals to gain insight into the amount of expected risk. They include:

• Technical analysis, which uses statistics along with share prices, historical returns, and trade volume
• Fundamental analysis, which looks at all aspects of the organization’s assets, including earnings, to estimate risk
• Quantitative analysis, which uses financial ratio calculations primarily based on the way the company performed in the past

Example of Financial Risk

Toys “R” Us is a good example of estimating financial risk. In September of 2017, the toy retailer announced it filed for Chapter 11 bankruptcy voluntarily and stated it was working alongside its debtholders and creditors to develop a plan to restructure the company’s $5 billion worth of long-term debt.

This financial risk came from a leveraged buyout of the company by Bain Capital, KKR & Co., and Vornado Realty Trust in 2005, according to reports from CNN. That debt was worth $6.6 billion. This is an example of debt-heavy buyouts and capital restructuring.

However, the restructuring of that debt did not pay out and in March of 2018, Toys “R” Us announced it would liquidate its assets. These assets included 735 brick-and-mortar locations across the U.S. This is an example of real estate liquidity risk since the company struggled to find buyers for its properties, limiting the company’s access to much-needed revenue and cash to offset its debts.

In November of 2018, Solus Alternative Asset Management and Angelo Gordon took over control of the company with the goal of reviving the chain at some point. In 2019, the company opened two locations called Tru Kids Brands. Additionally, the organization struck a deal with Macy’s in 2022 to create 400 new physical toy store locations within Macy’s locations.

Summary

Overall, financial risk presents the chance for both potential financial losses and rewards. The different forms of financial risk affect businesses, individuals, economies, and markets in a variety of ways.Each can be mitigated with the use of risk management tools and calculations.