There are always risks related to business financing. These include interest rate risk, liquidity risk, credit risk and exchange rate risk. There are many ways you can protect yourself from financing risks. When you are considering your company’s risk management as a whole, also take the risks related to financing into account.
An interest rate risk is caused by changes in interest rates in the financial markets. It applies to both loans and investments. Interest rate risks include price risk and interest flow risk.
Price risk means that when the interest rate changes, the present value of your company’s debt or receivable changes. For example, if interest rates are increasing, your company’s loan servicing expenses get higher and the value of fixed-rate investments decreases. The longer the time after which the interest is revised, the greater the risk.
Interest flow risk emerges if your company has debt or receivables whose interest varies. For example, if your company’s interest rate is tied to three-month Euribor rate, the interest may vary considerably once every three months. The shorter the time after which the interest is revised, the greater the risk.
You may protect yourself against interest risks by having at least some of your company’s loans or investments have a fixed interest rate. You can also agree on an interest rate cap or floor to keep the interest within agreed limits regardless of the general interest level.
Interest-rate derivatives also protect you against interest rate risks. For example, you may draw up an interest rate swap with your bank, which allows you to exchange your interest from a variable rate to a fixed rate or vice versa.
Follow how interest rates develop and aim to anticipate them.
Your company is facing a liquidity risk if it is unable to
- turn its assets into money or
- acquire other funding quickly enough to pay for its invoices.
A risk may emerge even if your company is making a profit and its finances are in balance. In this case, the risk results from the fact that you have not taken care of your company’s short-term liquidity. Liquidity issues hinder your company’s operations and may lead to insolvency.
You can protect your company against liquidity risks. Make sure that your company will always have money for payments in the short term. Be aware when money comes out of or goes into your cash reserve. Be active in following your company’s cash flows and economic indicators. If your company’s financial situation is poor, agree with your accountant on following key indicators and cash flows.
Decentralise your company’s financial assets in a manner that allows you to always release some funds for payments. Agree with you bank on the most suitable account and financial transaction arrangements. For example, you may get an account with an overdraft for your company, in which case there will also be enough money available during off-seasons.
A credit risk emerges when your company sells goods to its customers on credit. If the payments from your customer are late, your company may face financial issues. If your customer is completely unable to pay receivables to your company, your company may face bad debt.
A credit risk may also emerge if your company invests in the debt instruments of other companies or uses financial derivatives.
A credit risk is highest when the overall financial situation is poor and interests are high. If your customer’s interest risk is high and financial situation is poor, your company’s credit risk will grow.
You can protect yourself against credit risks by carefully selecting your customers, for instance through credit rating. Follow whether your customers are paying their bills on time and how their financial situation is developing. Ask your customers for guarantees or draw up precise agreements that include penalties. Price your company’s products so that the company will retain some profit regardless of possible bad debt.
If there is a delay in a customer’s payment, remind them right after the due date. Be consistent and go through all your receivables regularly. You can outsource monitoring receivables to the company that handles your accounting. Invoicing services may also follow your receivables and send automatic demands for payment for customers who have failed to make their payments.
You can also purchase credit insurance for receivables. Additionally, you can manage risks by utilising various guaranteed payment types such as a letter of credit.
An exchange rate risk means that the movements of exchange rates cause fluctuation in your company’s earnings, cash flows and balance. Take this risk into account in budgets, pricing, investments as well as foreign purchases and sales.
A transaction risk emerges if an exchange rate changes between drawing up an agreement and making a payment. For example, if a certain amount of dollars has been agreed as the price at the time of drawing up an agreement and the dollar’s value goes up, the payment you receive when the invoice is due is less in euros than it would have been at the moment of concluding the agreement.
A translation risk emerges when the sums processed as foreign currencies in accounting are exchanged for euros in the company’s financial statement. For example, if dollars are used in the accounting of your foreign affiliate and the dollar does up before drawing up a financial statement, the numbers on the statement in euros are smaller than they would have been earlier during the financial year.
An economic risk is caused by an effect of fluctuations in currency rates on your company’s competitiveness. For example, if the dollar is used as the currency in the industry of your Finnish company and the dollar’s value does down, your company will get less profit from its sales and might have to raise its prices.
You can protect yourself against exchange rate risks by agreeing on the exchange rate used in transactions. Moreover, if your company has sales in dollars, for example, you may also use the dollar as the currency used for purchases.
You may also acquire currency derivatives. For example, you may agree in advance on the exchange rate used for exchanging the trade price paid for by your foreign customer into euros with your bank.