5 steps for financial risk analysis
written by Juan Pablo Calle, On October 25, 2022
Financial risk analysis is the assessment of the likelihood of a threat occurring and its possible impact. Hence, its importance in risk management.
Financial risk management is the calculation of the potential effect of a risk and its degree of exposure.
This calculation is not an easy task, as a certain risk can trigger many effects. For example, a machine that stops working not only causes mechanical damage that needs to be repaired. It also interrupts production, generates losses, delays deliveries and can even affect the company's image.
Where to start?
The analysis of a company's financial risk begins after all possible risk events have been identified. In this article, we explain how to identify them.
The analysis is not only intended to estimate possible losses, but also to prevent them from occurring.
For example, a credit risk analysis, one of the main types of financial risks, assesses the possibility that a debtor may not be able to fulfill his/her obligations. With that information, the bank takes steps to prevent this from happening or mitigate the impact as much as possible.
That is why financial risk management must take into account the internal and external factors that give rise to threats.
Internal factors are those produced by the company's own commercial activity. Poor cash management or production problems are risks that can impact a company's accounts and market value.
In turn, external factors are the political, economic or social conditions that affect a company's performance, such as economic crises, exchange rate instability, variations in an industry or state policies.
The easiest method to conduct a financial risk analysis in a company is to combine the probability of a risk occurring and the possible economic losses that it can cause.
Once the risks have been identified and after choosing the most convenient tool to control the events, the company can decide whether to avoid or assume the risks according to the company's risk appetite and tolerance level
The degree of exposure to risk is measured quantitatively. If an event impacts only a specific area of the company, the potential effect can be estimated by multiplying the probability of the risk occurring by the approximate calculation of financial loss.
The result can be used to generate a graph of functions that would indicate which risks are tolerable and which are potentially dangerous.
Of course, when deciding, market trends and macroeconomic and financial variables must also be considered.
With so many circumstances to consider, the financial risk manager can use real-time risk detection tools to facilitate management and take preventive or mitigating measures. Risk management software is one such tool.
Below are the 5 steps to manage financial risks:
Step 1: Identify key risks
To begin the financial risk analysis, identify all the risk factors faced by your business. These risk factors include all aspects that affect competitiveness (costs, prices, inventory, etc.), changes in the industry to which the company belongs, government regulations, technological changes, changes in staff, etc.
Step 2: Calculate the weight of each risk
Prioritizing risks is critical to the efficient allocation of resources and efforts. That way, you can create a plan in case a threat materializes.
Step 3: Create a contingency plan
Analyze what you need to do to resolve the risks of item 1 and create specific tasks to mitigate the impacts. Remember that not all risks can be faced in the same way. In fact, you may not be able to control them all. That is why the contingency plan must be based on the risk appetite and tolerance level established by the company.
Step 4: Assign responsibilities
Although it is not possible to assign responsibilities for each risk, try as much as possible to have a person in charge of monitoring critical points and their evolution over time. At this point, avoid centralizing all responsibilities in one person. Delegate tasks to the most appropriate staff.
Step 5: Set expiration dates
Mitigation plans cannot be applied indefinitely, since threats can multiply and affect more processes. This somehow determines the actions to be taken, as they must be based on the time needed to carry out each task.