The abrupt failure of Silicon Valley Bank (SVB) in early March 2023 sent a panic through its depositors. With 17 branches in California and Massachusetts, the financial institution catered primarily to startups in the technology and healthcare sectors, and its customers faced the potential loss of substantial deposits and additional disruptions to their operations and bottom lines.
The headline-making collapse highlights the financial risks that loom over businesses of all stripes. While most of these risks can’t be entirely eliminated, proactive financial risk management can prepare you to better weather those that come to fruition.
This article covers the kinds of risks most businesses will face and how to adequately prepare for them to avoid everything from mild headaches to full blown catastrophes.
Financial risk categories
When you decide to launch a business, you assume risks inherent to the undertaking. Several different categories of risks are widely recognized, although some overlap exists. These include:
Credit risks come in two flavors. The first is the risk that a client or customer won’t pay its debt to your business. If you extend a customer financing, you risk the loss of the unpaid debt and interest, plus incurring additional expenses related to collections.
Credit risk also arises when you’re the one obtaining credit. Rising interest rates and revenue slumps can make it difficult to satisfy your payment obligations, leading vendors and lenders to discontinue credit transactions or cut you off altogether. If your credit rating suffers, future loans will come with higher price tags.
These are failures caused by employees, systems, processes and procedures, or external events. Your employees might make a costly mistake, perform poorly, manage poorly, or commit fraud. Your assembly line might break down, or you might violate a regulation. You could endure natural disasters, pandemics, or infrastructure problems. Any of these can slow your operations or bring them to a halt.
Liquidity risk refers to the possibility that you won’t be able to meet your short-term financial obligations because of a cash shortfall. You needn’t look any further for an example than SVB itself, which was confronted with a “bank run” that left it with a $1 billion negative cash balance. Your business is probably unlikely to find itself in a similarly dramatic scenario. Still, you could, for example, have to deal with seasonal or other revenue fluctuations that impair your ability to pay your bills.
For publicly traded companies, financial market swings can cause the loss of share value. One company’s struggles can become contagious in financial markets, yet another result that’s played out in the wake of the shutdown of the SVB by banking regulators.
But public and non-public companies should also focus on the conditions in the market in which they operate—the macro- and microeconomic and other risks to your industry. These might include the effects of climate change, the demand for environmental, social, and governance (ESG) policies, a lack of skilled labor, inflation, shifts in consumer demand, and supply chain issues.
The competitive landscape affects your market risk, as well. This includes your competitive disadvantages and threats such as new entrants.
Anyone who has started a business knows it usually comes with some governmental regulations and other legal requirements. You must also comply with many federal and state wage-and-hour, anti-discrimination, and tax laws. Noncompliance can bring hefty fines, penalties, damage awards from lawsuits, and reputational damage.
Additional risks to recognize
Reputational damage is another critical risk factor that can significantly impact your finances. That’s because there is such a thing as bad publicity.
Your company’s brand, or reputation, is a vital intangible asset. If it takes a hit from, for example, government investigations (whether civil or criminal), ethical breaches, inappropriate employee behavior, or social media missteps, you can lose valuable customer, investor, and vendor relationships. Even something as seemingly inconsequential as an irate online reviewer can have a long-lasting effect.
Data breaches and cyber crimes are among the biggest drivers of reputational damage and financial losses—because it’s not just you who can be victimized by a breach of your system, but also your customers. The move to remote or hybrid work has only increased the odds that cybercriminals will target your business with a costly attack. According to IBM and the Ponemon Institute, the cost of a data breach averaged $4.35 million in 2022. And a recent Verizon report found that 43 percent of breaches involved small business victims, so it’s not only large companies in the crosshairs.
Financial risk management tips
Financial risks are an inevitable part of starting and running a business, making effective financial risk management essential. While big companies often have dedicated staff to perform this function, it may be even more critical for smaller businesses, which typically operate with tighter profit margins and smaller or even no cash reserves.
Global management firm Gartner defines financial risk management as the process of evaluating and managing current and possible financial risk to reduce a business’s exposure to risk. By engaging in the process, you can reduce the odds of the risks occurring and mitigate the effects when they do.
The process might vary depending on the characteristics of a particular company, but it generally involves conducting a risk assessment to identify all the potential internal and external financial risks and quantify the likelihood and severity of each. You then evaluate the potential remedies, develop and implement strategies to combat the risk, and monitor the effectiveness of the strategies on an ongoing basis.
A variety of strategies is available. You might adopt a strategy of risk avoidance. For example, opting not to expand into a geographic or product area with strict regulatory requirements or a high rate of litigation. You could go the path of risk reduction, which might entail reducing your credit risk by conducting thorough credit checks or requiring advance payments. Risk transfer—say, purchasing cyber insurance—is another alternative. Your choice will depend on your “risk appetite” or the amount of risk you’re willing to accept in pursuit of your strategic objectives.
Cash flow management is also key to financial risk management, especially in an uncertain economy. Financial statement figures are important, of course, but don’t overlook the cash inflows and outflows that allow you to sustain daily operations, address unexpected challenges in a timely manner, and seize unforeseen opportunities. Take the time to develop quarterly or monthly cash flow forecasts so you can plan accordingly to preempt cash crunches that jeopardize your survival. (And as a bonus, strong cash flows can help you reduce your credit risk by allowing you to pay upfront without financing.
Additional strategies include maintaining cash reserves for at least six months of expenses (or, better yet, a year). You should also attempt to diversify your revenue streams. You don’t want to overly rely on a single customer or offering. Think, for example, of the distilleries that were able to quickly pivot to making hand sanitizer when their in-person business dried up during the pandemic closures.
Risks are a natural part of owning a business, but they require proactive strategies. If you don’t yet have the internal resources for effective financial risk management, ask a business advisor like your CPA how they can help.