What Do Entrepreneurs Need to Know About Financial Risk? (2023)

You’ve probably heard statistics about the rate of business failure for new ventures. It might surprise you to know that the majority of new businesses survive their first year. By five years, though, almosthalf of new businesses have shuttered their doors. Is there financial risk that will need to be taken into account.

There are many reasons for this situation, but some of the most common are cash flow issues and running out of cash.

It’s also easy to see why businesses may survive a year or two before disappearing from the scene. Most entrepreneurs are well aware of financial risks in the first few months of business.

By the time you reach five years, you might think businesses are somehow immune to risk. New technologies or the disappearance of a major account can spell trouble.

As you can see, there’s no point in a business’s life where it stops being risky. The best thing entrepreneurs can do is learn to manage financial risk effectively.

What Do Financial Risks Look Like?

Most entrepreneurs are familiar with the concept of financial risk.

Financial risks involve the way you handle the cash flowing in and out of the business. Taking on a new loan is a risk because it increases your financial obligations. Hiring a new employee is a risk because you’ll need to pay this person on a regular basis.

Financial risk could be almost any financial transaction in the business. This includes paying an employee to fund product development.

Some common financial risks include:

  • Poor cash flow management
  • Taking on too much debt
  • Not invoicing clients on time
  • Payroll and employee benefits

A late-paying customer can also be considered a financial risk for your business. A new client may be risky as well, especially if you don’t do a thorough background check. You may deliver products or services you never receive payment for.

External factors also present risks. A downturn in the economic markets may mean your investors decide to pull out of a deal. This represents a risk for you since you could lose funding.

No Pain, No Gain

There’s another word for “risk” in business: opportunity. Investing in your marketing plan during a downturn can be seen as a financial risk.

(Video) Why Take The Risk? | Job Security vs Entrepreneurship

You can also see it as an opportunity to find more customers. If your strategy is successful, you could end up growing the business.

The same is true of taking on debt. A pizzeria owner may need a new pizza oven to grow the business. The debt is a risk because there’s a chance they may not be able to pay it back.

It may also represent an opportunity. With the loan money, they buy a second oven to serve their customers even better experiences. They attract more customers as a result.

They might also decide to open a second location with the new oven. Now they can reach customers who didn’t buy before.

Business Risk vs Financial Risk

Keep in mind that financial risk is almost always a business risk. Business risk is not necessarily financial though.

A new competitor moving into your market is a risk to your business, but it’s not a financial one. The same is true of a downturn in the markets that leads to lower demand. Non-compliance with the law has financial impacts, but it’s not a financial risk.

[click_to_tweet tweet=”By 5 years almost half of the new businesses have shut down their doors. It’s easy to see why they may survive a year or two before disappearing from the scene. Most entrepreneurs are well aware of financial #risk in the first few months of #business.” quote=”By 5 years almost half of the new businesses have shut down their doors. It’s easy to see why they may survive a year or two before disappearing from the scene. Most entrepreneurs are well aware of financial #risk in the first few months of #business.” theme=”style1″]

Managing Risk the Right Way

As you can see from these examples, financial risk is a double-edged sword for most businesses. Spending money or bringing on new clients comes with a risk, but it’s also an opportunity.

The key is to manage financial risk more effectively for your business. Taking on a loan for new equipment only makes sense if it will help you grow the business or maintain operations.

Suppose our pizzeria owner’s oven breaks, but they can’t afford to replace it. Taking the loan is a risk, but they have to take it to keep their doors open. A pizzeria without an oven isn’t going to make much pizza, and they won’t be in business much longer.

Adding a second oven to their operation is also a risk, but it may be one that makes sense. After research, the owners discover people on the north side of town want more pizza choices. They don’t buy from this pizzeria, because the location is too far away.

Creating a second location is risky, but the owners know there are demands and interests. It’s a calculated risk that can help grow the business.

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The owners can take more steps to lower their risks. They may shop around for loans to see if they can find a lower interest rate. They may supply some cash from their savings to lower the loan amount, thus reducing debt and risk.

Risk Management Means Planning

One of the reasons businesses may not make it to five years is the failure to plan ahead. Risk management relies on good planning.

A five-year plan illustrates the point. The business owner may make plans for careful, stepped expansion over those five years.

Those expansion plans may hinge on growth. If growth doesn’t occur, then the business won’t take on new debts or hire more people. If growth is faster than expected, the business may need to hire more or decide to take on new debt sooner.

The plan should also make provisions for reviewing the business’s risk profile often. The plan should be flexible enough to accommodate new risks that emerge over time.

Managing Cash Flow as a Financial Risk

Another key to reducing financial risk for businesses is better cash flow management.More than 80 percent of businesses fail because of cash flow issues.

At its most basic, cash flow management is the art of balancing the money coming in with the money going out. There are simple steps to take to manage cash flow more effectively.

One is to reduce overhead so that there is more money coming into the business than leaving its coffers. This isn’t always possible. Cost-saving measures can still help improve cash flow.

Good policies around client billing can also help. If you invoice your clients, make sure they’re invoiced on time. Sending a reminder before the bill is due and following up on overdue bills is good practice.

You should also vet your clients before you bring them on. Does this client have a history of late payments or non-payments? If so, you may want to ask for a down payment or another upfront fee.

These measures can help you get paid on time. In turn, having funds arrive on time will help with your cash flow. Outstanding invoices and non-paying clients are financial risks for your business.

Other Types of Risks

As mentioned, debts are financial risks. Any sort of financial transaction, such as spending more on marketing or paying new employees, is another risk.

(Video) Mentor Monday: Managing Financial Risk as an Entrepreneur

Employee benefits can become financial risks for your business. Suppose an employee has a health savings account. One day, they decide to cash it all out.

You have to pay them out, but where is that cash coming from? If you haven’t managed your risks properly, it might be coming out of a loan payment or your operating budget. Employee backpay can present a similar problem.

There are legal dimensions to financial risks as well. A change in the law may increase your financial risk by increasing how much you need to pay employees for overtime.

Managing cash is thus key to managing financial risk. Leveraging risk well will help you grow the business. Managing it poorly could lead to the closure of the business.

Getting Help with Risk Management

Planning for and managing risks is something of an art for most people. It can be difficult to see the future. What new threats may emerge?

Entrepreneurs may also be focused on the here and now. That’s why it can be helpful to work with a financial risk manager.

What Is a Risk Manager?

A financial risk manager is a trained professional. They’ve taken the FRM exam and have financial risk management certification.

They can use their expertise to help you plan for and manage risk more effectively. They’re well-versed in identifying and evaluating risks.

They can consult theirFRM notesto help you develop a strategy to manage risk for your business. As we mentioned, risk never disappears for businesses. Managing it the smart way is thus crucial.

Good risk management can also help you grow your business. Your manager should make recommendations to leverage risk and grow your business.

Nothing Ventured, Nothing Gained

Financial risk is a natural part of any business. Learning how to manage it the right way will power your business to success.

Looking for more great financial tips for your next venture? Take a look at our informative articles for the best advice.

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FAQs

What is financial risk in entrepreneurship? ›

What Is Financial Risk? Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk. Financial risk is a type of danger that can result in the loss of capital to interested parties.

Why is an entrepreneur willing to take on financial risk? ›

Entrepreneurs take risks because they're necessary to start and grow a business. Some of the risks an entrepreneur might face include: Leaving a full-time job and steady paycheck. Using personal savings with no guarantee of a return on investment.

Why is it important for entrepreneurs to consider risks? ›

Business leaders accept risk as a cost of opportunity and innovation. They know it cannot happen if you will not accept the risk that your undertaking might fail. The level of risk may be lessened, however, if you make all possible calculations and evaluate which options are best before proceeding to the next step.

Which is the most important factor that an entrepreneur should consider before taking the risks of opening a new business? ›

It's important to research your industry, find competitors, understand risk and map out your finances before starting your business.

Why financial risk is important? ›

Benefits of Financial Risk Management

It helps the firm to coordinate and control necessary business data and processes. It provides a better understanding of the opportunity for performance measurement and profit sources. You can link your economic cycle with the factors of model risk.

How do you manage financial risk? ›

Financial risk management
  1. identify and measure the risks.
  2. decide on the level of risk you are willing to accept.
  3. consider insurance to protect against business risk.
  4. identify potential issues with cashflow.
  5. review your financial arrangements with creditors.
  6. be careful if extending credit to customers.

How can taking risks lead to success? ›

Taking risks allows us to expand the parameters of our experiences. By widening the parameters and increasing the variables within our lives, we effectively increase the number of 'random' events that can arise – what some might call 'luck'.

How can you improve risk taking? ›

​5 Tips for Taking Better Risks
  1. Develop a system for assessing risk. The first place to start when weighing a big risk is to write out a list of all the pros and cons. ...
  2. Move past the fear of failure. ...
  3. Think about the upside of change. ...
  4. Find ways to take on incremental risk. ...
  5. Seek out advice from calculated risk-takers.
2 Nov 2021

Why do entrepreneurs take the risk of starting a business for all of the following reasons except? ›

Entrepreneurs take the risk of starting a business for all of the following reasons except d. they want to work less.

What is risk and why is it important? ›

Any factor or event that creates uncertainty in achieving organizational objectives is “risk”. These risks can be in the form of financial uncertainty, strategic oversight, legal liabilities, IT and data-related threats, or natural disasters.

Why risk management is important in business? ›

The risk management process

Businesses face many risks, therefore risk management should be a central part of any business' strategic management. Risk management helps you to identify and address the risks facing your business and in doing so increase the likelihood of successfully achieving your businesses objectives.

Why did we need to have to take risk when making decision? ›

Risk is an essential component of business decisions. Risk arises because it is impossible to predict outcomes: uncertainty is always with us. Risk is the potential for adverse impact of areas of uncertainty on a decision or action path.

How do entrepreneurs handle risk? ›

Risk-takers don't think about the escape route, the factors that make it risky, and what the situation will be if they fail. Entrepreneurs take calculated risks; they're willing to “go big or go home” but they understand the consequences if they fail and have taken into account the likelihood that they'll succeed.

What are the most important factors to consider before they start their business? ›

Well, there are some important factors to bear in mind when launching a business.
  • A great idea. “No business can develop in the absence of a great idea. ...
  • Funding and budget. ...
  • What is your business plan? ...
  • Legal documentation. ...
  • Passion. ...
  • Find the right equipment. ...
  • Know when you need help.

What factors Each entrepreneur needs to take into account to ensure business success? ›

Entrepreneurship: 5 Critical Success Factors
  • Sacrifice – Are you willing to sacrifice short term to benefit in the long term? ...
  • Experience – Do you have some business or related experience? ...
  • Leadership – Do you like being the leader? ...
  • Organization – Are you organized? ...
  • Optimism – Are you optimistic?

How does financial risk affect a business? ›

Credit risk can impact your business in 2 ways: the risk of borrowing money and not being able to meet your repayments (more commonly a liquidity risk) balancing the risk of extending credit to your own customers (debtors) against the probability of them defaulting on their payments.

What is financial risk and example? ›

Financial risk is a broad category for a few different types of risk as there is more than one way a business or an investment can lose money. Examples of financial risks are market risk, credit risk, liquidity risk, and operational risk.

What is the purpose of financial risk management? ›

Financial risk management is a function within organizations that aims to detect, manage, and hedge exposure to various risks stemming from the use of financial services.

How do you identify financial risks? ›

To identify financial risk, start by carefully reviewing your corporate balance sheet or statement of financial position. You will want to understand what your main sources of revenue are and how customer credit terms affect this revenue.

What factors contribute to financial risk? ›

Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more.

What are the main financial risk management tools and techniques? ›

Three commonly used approaches to quantifying financial risks are regression analysis, Value-at-Risk analysis, and scenario analysis.

Is taking risks an important part of growing up? ›

But risk-taking is part of growing up, too, helping teens to develop independence and identities—to start becoming adults. Risks help them to find out what they can do, and to gain insight into the meaning of their lives.

What does risk-taking mean in business? ›

Definition of risk-taking

: the act or fact of doing something that involves danger or risk in order to achieve a goal Starting a business always involves some risk-taking.

What is your understanding of the word risks? ›

: possibility of loss or injury : peril. : someone or something that creates or suggests a hazard. 3. : the chance of loss or the perils to the subject matter of an insurance contract. also : the degree of probability of such loss.

How do you take smart risks? ›

Smart risk-taking involves passion, planning, active learning, communication, and the ability to embrace and reward the inevitable small failures along the way. The application of Sundheim's smart risk paradigm can transform businesses and personal lives.

Which of the following motivates entrepreneurs to take risk? ›

The lure of profits motivates entrepreneurs to take risks and start businesses.

Which of the following are risks for entrepreneurs in small business? ›

  • Funding of capital.
  • Adequate cashflows.
  • Social and family pressures.
  • Interference with personal lives.
  • psychological pressure.
  • Lack of motivation.

What are the key problems an entrepreneur may face while running a business? ›

The top 10 challenges faced by entrepreneurs today
  • Cash flow management.
  • Hiring employees.
  • Time management.
  • Delegating tasks.
  • Choosing what to sell.
  • Marketing strategy.
  • Raising capital.
  • Strapped budget.
20 Apr 2022

What do you call the risk in entrepreneurship? ›

Business risk is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail. Anything that threatens a company's ability to achieve its financial goals is considered a business risk. There are many factors that can converge to create business risk.

What is risk analysis in financial management? ›

Risk analysis is the study of the underlying uncertainty of a given course of action and refers to the uncertainty of forecasted cash flow streams, the variance of portfolio or stock returns, the probability of a project's success or failure, and possible future economic states.

How do entrepreneurs cope with risk and uncertainty? ›

Entrepreneurs face uncertainties on daily basis and they must prepare by improving their mental stability – acceptance, flexibility, open-mindedness – and business preparation – study the risk, predict the future, create the future, adapt to the demands of the business environment.

Do entrepreneurs find ways to avoid business risk? ›

In reality, successful entrepreneurs avoid risks whenever possible. Successful entrepreneurs are focused on earning a profit from their activities. Consequently, they avoid taking risks that could lose them money. As an entrepreneur, you must make profit-seeking the center of your activities.

What characteristics does an entrepreneur need? ›

10 Characteristics of Successful Entrepreneurs
  • Curiosity. Successful entrepreneurs have a distinct personality trait that sets them apart from other organizational leaders: a sense of curiosity. ...
  • Structured Experimentation. ...
  • Adaptability. ...
  • Decisiveness. ...
  • Team Building. ...
  • Risk Tolerance. ...
  • Comfortable with Failure. ...
  • Persistence.
7 Jul 2020

What is the most important factor in business? ›

Most business have the Product thing covered, delivering a good enough product or service to be successful. From countless research results, Marketing and Sales and Money is the small business biggest challenge. But the One key factor responsible for most success and failure is Money management.

What decisions must an entrepreneur make when starting a small business? ›

9 Decisions Every Entrepreneur Must Make
  • Whether to act on their idea. ...
  • Whether to give up or persist in the face of failure. ...
  • Which experts to consult. ...
  • What the core values of their company will be. ...
  • Whether to seek external investment or not. ...
  • Their ideal customer. ...
  • How they'll price their products.
19 Jul 2021

What key areas of knowledge do you need to improve yourself more after going into business? ›

Here's an overview of why it's important to improve your business skills and ten you should prioritize to advance your career.
...
Business Skills Every Professional Needs
  • An Understanding of Economics. ...
  • Data Analysis Skills. ...
  • Financial Accounting Skills. ...
  • Negotiation Skills. ...
  • Business Management Skills.
23 May 2019

What is most important for an entrepreneur to succeed? ›

Key Takeaways

A great entrepreneur must be able to effectively communicate, sell, focus, learn, and strategize. An ability to continuously learn is not just a key entrepreneurial skill, but also a very valuable life skill. Growing a business requires a sound strategy based on inherent business sense and skills.

What makes an entrepreneur becomes successful? ›

Passion, resourcefulness, willingness to improvise and listen to others and strong determination to succeed is what makes an entrepreneur successful. And this is what you have to keep in mind as well if you want to be a successful entrepreneur yourself.

What made entrepreneurs succeed in their business? ›

One of the reasons why successful entrepreneurs succeed is because they know their target market very well. They have conducted prior research about the business that they want to build and pursue. They create a customer persona. They know very well the demographics of their customers.

What is financial risk and example? ›

Financial risk is a broad category for a few different types of risk as there is more than one way a business or an investment can lose money. Examples of financial risks are market risk, credit risk, liquidity risk, and operational risk.

What is financial risk and business risk? ›

Financial risk refers to a company's ability to manage its debt and financial leverage, while business risk refers to the company's ability to generate sufficient revenue to cover its operational expenses.

What are the 4 types of financial risk? ›

There are many ways to categorize a company's financial risks. One approach for this is provided by separating financial risk into four broad categories: market risk, credit risk, liquidity risk, and operational risk.

What are 5 financial risks? ›

Types of Financial Risks
  • Market Risk: This type of risk arises due to the movement in prices of financial instrument. ...
  • Credit Risk: This type of risk arises when one fails to fulfill their obligations towards their counterparties. ...
  • Liquidity Risk: ...
  • Operational Risk: ...
  • Legal Risk:
22 Sept 2022

How do you determine financial risk? ›

The most common ratios used by investors to measure a company's level of risk are the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio.

Why is it important to manage financial risks and rewards? ›

Understanding the relationship between risk and reward is a crucial piece in building your investment philosophy. Investments—such as stocks, bonds, and mutual funds—each have their own risk profile, and understanding the differences can help you more effectively diversify and protect your investment portfolio.

How can you avoid financial risk? ›

Here are some of the most common ways you can properly manage financial risk:
  1. Carry the proper amount of insurance.
  2. Maintain adequate emergency funds.
  3. Diversify your investments.
  4. Have a second source of income.
  5. Have an exit strategy for every investment you make.
  6. Maintain your health.
  7. Always read the fine print.
18 Mar 2013

What are the financial risks of a company? ›

These are credit risk, market risk, operational risk, liquidity risk, legal risk, and equity risk.

What are the different types of financial risks? ›

There are 5 main types of financial risk: market risk, credit risk, liquidity risk, legal risk and operational risk. If you would like to see a framework to manage or identify your risk, learn about COSO, a 360º vision for managing risk.

What is the meaning of financial risk management? ›

Financial risk management is the process of evaluating and managing current and possible financial risk to decrease an organization's exposure to risk.

What are the 5 main risk types that face businesses? ›

Here are five types of business risk that every company should address as part of their strategy and planning process.
  • Security and fraud risk. ...
  • Compliance risk. ...
  • Operational risk. ...
  • Financial or economic risk. ...
  • Reputational risk.
16 Jun 2021

What is risk types of risk? ›

Types of Risk

Broadly speaking, there are two main categories of risk: systematic and unsystematic. Systematic risk is the market uncertainty of an investment, meaning that it represents external factors that impact all (or many) companies in an industry or group.

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