You’re managing risk in corporate finance. What are the most important things to consider?

1 Identify the sources of risk

The first step is to identify the sources of risk that affect your financial performance. These could be market risk, credit risk, operational risk, liquidity risk, or any other factors that could create uncertainty or volatility in your cash flows, assets, or liabilities. For example, market risk refers to the changes in prices, rates, or exchange rates that could affect your investments or obligations. Credit risk refers to the possibility of default or non-payment by your counterparties or customers. Operational risk refers to the failures or disruptions in your processes, systems, or people that could cause losses or damages. Liquidity risk refers to the difficulty or cost of converting your assets into cash or meeting your obligations on time.

2 Measure the impact of risk

The next step is to measure the impact of risk on your financial performance. This involves quantifying the potential losses or gains that could result from different scenarios or events. There are various methods and tools to measure risk, such as sensitivity analysis, scenario analysis, value at risk, or stress testing. For example, sensitivity analysis shows how your cash flows or profits change with respect to a change in one or more variables, such as interest rates, exchange rates, or sales volume. Scenario analysis shows the impact of different combinations of variables or assumptions on your cash flows or profits. Value at risk shows the maximum loss that you could incur with a given probability over a given period. Stress testing shows the impact of extreme or adverse scenarios on your cash flows or profits.

3 Manage the exposure to risk

The final step is to manage the exposure to risk according to your risk appetite and objectives. This involves choosing the appropriate strategies and instruments to reduce, transfer, or accept the risk. There are various ways to manage risk, such as diversification, hedging, insurance, or mitigation. For example, diversification means spreading your investments or activities across different markets, sectors, or products to reduce the correlation and concentration of risk. Hedging means using derivatives or other contracts to offset the exposure to a specific risk, such as interest rate risk or currency risk. Insurance means transferring the risk to a third party that agrees to compensate you in case of a loss or damage. Mitigation means implementing actions or policies to prevent or reduce the likelihood or impact of a risk, such as improving your internal controls, compliance, or quality standards.

Managing risk in corporate finance is a complex and dynamic process that requires constant monitoring and evaluation. By following these steps, you can improve your decision-making and performance in the face of uncertainty and volatility.

4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?