What is Financial Risk

The term financial risk is the probability of losing money on an investment or business. Credit risk, liquidity risk, and operational risk are some of the most common financial risks.

Financial risk is a type of danger that can result in the loss of capital to interested parties. From the point view of the governments, this can mean they are not able to control monetary policy or other debt issues. Corporations also face the possibility of default on debt they undertake but may also experience failure in an undertaking the causes a financial burden on the business.

Various macroeconomic forces may cause financial risk, changes to the market interest rate and the possibility of default by sectors or large corporations. Individuals face financial risk when they make decisions that may put them in a condition that their income or ability to pay a debt they have assumed reduces.

Financial risks are everywhere and come in many sizes, affecting everyone. You should be aware of all financial risks. Knowing the dangers and how to protect yourself will not eliminate the risk, but it can mitigate their harm.

Types of financial risk

Market Risk

Market risk involves the risk of changing conditions in the specific market in which a company operates. One example of market risk is the increasing tendency of consumers to shop online. This aspect of market risk has presented significant challenges to traditional retail businesses.

Companies that have been able to make the necessary adaptations to serve an online shopping public have thrived and seen substantial revenue growth, while rest of the companies saw substancial market price reduction.

This example also relates to another element of market risk,the risk of being outperformed by competitors. In an increasingly competitive global marketplace, with narrowing profit margins, the most financially successful companies are most successful in offering a unique value proposition that makes them stand out from the crowd and gives them a solid marketplace identity.

Credit Risk

Credit risk is the risk businesses causes by extending credit to customers. It can also refer to the company's own credit risk with suppliers. A business takes a financial risk when it provides financing of purchases to its customers, due to the possibility that a customer may default on payment.

A company must handle its own credit obligations by ensuring that it always has sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise, suppliers may either stop extending credit to the company or even stop doing business with the company altogether

Liquidity Risk

It is the risk which includes asset liquidity and operational funding liquidity risk. It is the relative ease with which a company can convert its assets into cash should there be a sudden, substantial need for additional cash flow.

Seasonal downturns in revenue can present a substantial risk if the company suddenly finds itself without enough cash on hand to pay the basic expenses necessary to continue functioning as a business. This is why cash flow management is critical to business success and why analysts and investors focus on metrics such as free cash flow when evaluating companies..

Operational Risk

Operational risks refer to the various risks that can arise from a company's ordinary business activities. The operational risk category includes lawsuits, fraud risk, personnel problems, and business model risk, which is the risk that a company's models of marketing and growth plans may prove to be inaccurate or inadequate.

Financial Risk Models

Financial risk modeling is the process of determining how much risk (measured in volatility) is present in a particular business, investment, or series of cash flows.

Following are the financial models perticularly use:

1) Discounted Cash Flow (DCF) Model

The DCF model builds on the 3 statement model to value a company based on the Net Present Value (NPV) of the business’ future cash flow. The DCF model takes the cash flows from the 3 statement model, makes some adjustments where necessary, and then uses the XNPV function in Excel to discount them back to today at the company’s Weighted Average Cost of Capital (WACC).These types of financial models are used in equity research and other areas of the capital markets

2) Merger and Acquisition Model (M&A)

The M&A model is a more advanced model used to evaluate the pro forma accretion/dilution of a merger or acquisition. It’s common to use a single tab model for each company, where the consolidation of Company A + Company B = Merged Co. The level of complexity can vary widely. This model is most commonly used in investment banking and/or corporate development.

3) Leveraged Buyout (LBO) Model

A leveraged buyout transaction typically requires modeling complicated debt schedules and is an advanced form of financial modeling. An LBO is often one of the most detailed and challenging of all types of financial models, as the many layers of financing create circular references and require cash flow waterfalls. These types of models are not very common outside of private equity or investment banking.

4) Option Pricing Model

The two main types of option pricing models are binomial tree and Black-Scholes. These models are based purely on mathematical formulas rather than subjective criteria and thus excel calculator can be used.