Last week we examined operational risk and now shift focus to financial risk. Financial risk arises from the risk to profits or wealth due to uncertainties about the financial situation in the future. It is broadly categorized into market risk and credit risk. Market risk has to do with changes in the general business environment specifically changes in prices and rates. It is further broken down to the following subcategories.

Interest Rate Risk. This is the risk that interest rates will change. Many businesses in Kenya must have experienced an adverse movement from last year especially if they were servicing loans. We have seen profits of reputable companies wiped out because they had to pay higher interest than had been budgeted for.

Currency Risk. This is the risk that forex rates will change. Again, many businesses in the import/ export business face this risk as foreign exchange rates keep fluctuating. The interesting thing with this risk is that when importers are celebrating, importers will be crying. Any movement in forex rates has a reverse effect on each group.

Equity Risk. This is the risk that share prices will change. The average small business may not be exposed to this risk unless the owners have made significant investment in the stock market. Large companies aim at increasing shareholder wealth and hence take a beating when share prices drop.

Commodity Risk. This is the risk that prices of various commodities will change. We do not have a regulated commodities market in Kenya and so may not keep track of commodity prices but the general trend is seasonal variation in prices depending on supply.

Liquidity Risk. This is the risk that a business will not have money to meet obligations/ payments as and when they fall due. This is a most dangerous risk because businesses collapse when debtors recall money owed when the business needs it most.

Concentration Risk. This refers to the risk of not diversifying your suppliers/ customers. When in business, it is dangerous to have one big supplier or one big customer you entirely depend on. When the supplier/ customer’s business has a problem, you suffer too. Worse still, when they go out of business, chances are you could follow them down. We might have read the story of Jetlink whose business in South Sudan has ground to a halt threatening the viability of the aviation company.

Credit risk arises from the possibility that your customers will default on their payments when due. This mainly affects businesses that sell on credit. An effect of such default is that your cash flows are disrupted and it might also increase the costs of following up debt.

The other general financial risk is called country risk. This is felt by multinational businesses working in different jurisdictions. Back to the example of Jetlink in Southern Sudan. Since the nation practically has run out of dollar reserves Jetlink has accumulated a lot in the local currency that is not useful outside the country. At one point or another, we have made jokes of the inflation in Zimbabwe that caused businesses to suffer a lot. These are just two examples to demonstrate that there are some country specific risks encountered by choosing to do business there.

In general, financial risk is managed by use of thorough credit analysis and adoption of credit ratings. That is why lenders ask for historical business records and perform a basic character definition of a customer before lending. At the international level, lenders use reports from credit rating agencies like Moodys or Standard & Poors to help determine credit applications.

Many small businesses may not have the resources or manpower to do credit analysis. However, they make decisions based on their judgment of the customer’s historical repayment record and character assessment to mitigate possible risks