Learn about the following different financial types of corporate risks, including business, market, credit, liquidity, and counterparty risks. Get examples of each of these five categories of financial corporate risk.
- I know a CEO who likes to say, "You never go broke by making a profit." When it comes to business, truer words have never been said. But in the quest to make a profit, companies face a number of financial risks. Risks that are directly related to turning a profit, managing financial market risks, and having enough cash coming in to keep the business going. Let's take a look at five financial risks companies face. These include business, market, credit, liquidity, and counterparty risks.
I'll walk you through these risks, and offer some insights to help you identify them in your own company. The first kind of financial risks are business risks. And the first rule of business is buy low and sell high. That's how you make a profit. Business risks exist if that isn't possible. Because if you can't make a profit, you simply don't have a business. Of course, a business can lose money for a little while, and it's even expected when a business is starting up.
But eventually, businesses need to turn a profit. Without hope of any eminent profits, or any actual current profits, there isn't hope for a business. Let me tell you a story. There's a man who sells cars for $25,000, but they cost $30,000 to make. He's losing money on every sale. One day a lady goes up to him and asks how he can do business losing money. And the guy says, "I make it up on volume." This isn't a real story, it's actually a joke.
Because you can make up for a narrow profit margin by selling at a greater volume, but there's no offset for a business that loses money on each sale. It's not what business people call a sustainable model. Which means you'll go out of business pretty quickly, and that's business risk. The second kind of financial risks are market risks. Market risks threaten a company because financial markets move. The most important financial market risks in the world of corporate finance are interest rates, foreign exchange rates, currencies, and commodity price risk that comes from oil, corn and steel.
These risks can drastically affect the profitability of a business. Higher interest rates affect the cost of capital. Currencies can drive up the cost of goods, or drive down the sale price. And commodity prices can do the same. They can hurt the ability of a business to buy low and sell high. This is why these risks are the most commonly hedged, to limit costs and to protect profits. The third kind of financial risks are credit risks. Walt Disney once said, "It's not what you have, "but how much you can borrow that's important in business." Credit is important to keeping a business going, and to help it grow.
Just like with an individual credit score. If a company's perceived corporate creditworthiness falls, the cost of credit for that company will rise. Downgrade risk is the risk that a company will have its perceived corporate rating lowered. And that would be a downgrade. It's like a company seeing its credit score drop. And a drop in a company's credit score, a downgrade also makes the cost to borrow money rise. This is an important risk to consider internally.
The fourth kind of financial risks are liquidity risks. For a business, liquidity risk is the potential risk that a company could go into default or bankruptcy because it lacks the capital to stay liquid. Because it lacks the cash, or credit, to pay its bills. For things like wages, equipment, and other costs. Companies don't go out of business by issuing too many shares. They go out of business because they have no money, no credit, or they cannot meet their debt obligations. A business needs access to cash and/or credit, and the risk of those going away is a company's liquidity risk.
In order to buy low and sell high, you have to be able to buy low in the first place. Without liquidity you can't. If you spend too much money on equipment or on a long-term lease for a fancy office, you might not have enough cash on hand to be liquid and keep a business going in the day-to-day. This is why, in order to keep a business going, you must be liquid. The fifth kind of financial risks are counterparty risks. No matter what strategy you use to manage your risks, if another party is involved you're counting on them to hold the net if you fall from the trapeze.
They are your counterparty. And the risk that something happens to them is counterparty risk. If you buy goods or services from a vendor you have counterparty risks. This is true if you buy insurance, sign a long-term contract, or hedge your risks with a counterparty. When companies hedge their risks, they do it with physical or financial counterparties. An airline might hedge its jet fuel costs in an agreement directly with a refinery. A car manufacturer might have a long-term agreement with a steel factory.
But if that refinery or that steel factory goes out of business, what will your company do then? To reduce this kind of counterparty risk, a lot of hedging has been done through third parties like banks or merchant traders. Of course, even if your hedge counterparty, like a bank, goes out of business your hedge could come undone. During the great recession of 2007 to 2009 when Lehman Brothers went out of business, counterparty risks hit companies that thought they were safe. One major steel company had responsibly hedged its steel price risks to sell their steel at a high price.
But when Lehman went out of business these hedges evaporated and it hurt the steel company's bottom line when steel prices fell. The main takeaway here is, choose your vendors and business partners wisely. Know that if they suffer, you could suffer as well. How do you feel about the financial and business continuity for your insurance company, bank, vendors, and other counterparties?
Jason Schenker of Prestige Economics discusses nine types of corporate risk, including financial and nonfinancial risks. He explains the difference between direct risks that companies face constantly, as well as indirect risks that usually come from vendors, competitors, and counterparties. Then he covers how risks are typically resolved, either by elimination (divestiture or acquisition), transfer (hedging or insuring), offset (creating a natural hedge), or ownership (keeping the exposure). Finally, he reviews how corporations can actively measure and monitor risk by appointing dedicated risk managers, officers, and committees.
- Understanding risk in corporations
- Risk management process
- Nine different types of corporate risks
- Financial market risks
- Direct and indirect risks
- Risk management solutions
- How corporations actively manage risk