Only 80 percent of businesses will survive their first year, only 50 percent make it past year five, and only 30 percent survive in business for 10 years or more, according to data from the Bureau of Labor Statistics.1 Every business encounters risk, and the fallout from poorly managed risks can be enough to cripple a business.
Credit risk, interest rate risk and liquidity risk are three common risks businesses face. Here’s what they mean, why they’re important, and some tips for how to mitigate them.
When you use a credit card, your issuing bank is providing you with free funds to use. If you don’t pay these funds all back at once by the determined due date, you’ll likely be paying interest fees. There’s even a chance that you won’t pay back what you owe at all, which is a risk the lender takes when they agree to issue funds to you. Just like a financial institution assumes credit risk whenever it gives a new line of credit to a customer, a business can incur credit risk, too.
Credit risk is the risk a business takes when it provides a loan, product or service without upfront payment. This risk is common in all kinds of businesses. A graphic designer takes on a project with the agreement they’ll get paid upon completion. A hospital performs a life-saving surgery, then bills the insurance company after. A delivery person may get paid after goods are delivered.
Any business that provides something and gets paid later takes a credit risk. Some ways to mitigate this type of risk include:
- Investigating new clients. Before agreeing to work with a new client, ask for referrals. Inquire about their payment punctuality. Check out their Better Business Bureau rating. If this client is an individual, look up their credit score. Or, use a tool like Experian to view business credit reports.2
- Getting partial payment upfront. Some businesses will bill for half of a project’s price upfront and bill for the rest upon completion. Others invoice on a recurring basis, so some form of payment is always coming through at a reliable cadence.
- Outlining extensive contractual details. Any payment agreement should include details about what will happen if payment is not received on time or at all, including details about interest fees for late payments and actions the business will take to recoup missed payments.
Ideally, a business will have a solid relationship with every other business it works with, but that’s not always the case. Research, contracts and billing systems can help protect a business against credit risk.
Interest Rate Risk
In 2017, the average loan extended to businesses in the U.S. was $663,000, according to ValuePenguin.3 Loans enable owners to start their businesses; manage expenses; expand inventory, location or market reach; and provide safety nets to stay afloat.
Whatever the reason, every business loan means there is interest rate risk involved. Interest rate risk is the risk that the value of a loan will change due to fluctuating interest rates. If an interest rate increases, businesses with outstanding loan debt will have to pay more, which can impact their operations.
Here are some ways a business can mitigate interest rate risk:
- Shorten loan terms. The shorter the terms of the loan, the less damage will occur due to rising interest rates. Even if rates do go up, because the business has agreed to pay back the loan in a certain amount of time, there will be a shorter time period during which the business takes a hit.
- Take out loans at the right time. A business owner can monitor business loan interest rates and only strike when rates are low. When the dollar is performing well throughout the market, interest rates should be lower, too.
- Use risk management products. Various financial institutions offer different products and loan models to keep interest rates reasonable for businesses. For example, Webster Bank, a large commercial bank on the East Coast, provides interest rate swaps, interest rate caps and interest rate collars (simultaneous interest rate caps and floors).4
Business owners should talk with lenders about options that can help them secure low interest rates and avoid exposure to rate fluctuation.
Liquidity risk is a risk businesses face that can take several forms, including:
- When a business has assets that may not be able to be sold for their true value or for a profit
- When there is not enough cash or cash equivalents to meet financial demands such as order fulfillment or payroll
- When a business has inventory that will not be sold at all because of a lack of consumer desire
Every single item or service a business purchases affects its liquidity risk. If a business owes money, liquidity risk is even more serious.
Steps to mitigate liquidity risk include:
- Avoiding risky assets. A business might need office equipment and a staff kitchen, but does it really need the latest in high-end design or a fancy espresso machine? Small businesses with lean beginnings should be especially cognizant of what type of value each new purchase has, how it affects productivity and how much it could be resold for if necessary. Risky assets can also include software with no automatic updates or technology that is already outdated.
- Avoiding acquiring too many assets. In periods of growth, some small business owners may be tempted to spend profits immediately in an effort to continue their success. Opening another office, purchasing new computers or loading up on inventory can all be too much, too soon.
- Tracking assets. Asset management, such as constant, real-time attention to what assets are in stock and on hand, is key to avoiding crises of liquidity. Failure to track this information could lead to purchases of excess inventory or the erroneous assumption that inventory has been lost or stolen. While manually tracking assets on a spreadsheet is a viable option, asset management software may be a beneficial asset to invest in for businesses with extensive and complex assets.
- Selling when the time is right. If a business no longer has the need for a certain asset and an interested buyer appears, selling might make sense. Items that can become outdated or undesirable in the future could fetch a better profit when they’re sold in the present. Business owners who know they want to sell something can also monitor the market to see when prices are in their favor to sell.
Accurate tracking of assets being purchased and used by a business is critical. That way, no matter how big a business grows, it still operates with a lean mentality that keeps it financially fit with minimal risk.
Master Risk Management With an MBA
Credit risk, interest rate risk and liquidity risk are serious enough for many businesses to hire dedicated risk managers or include risk management as a key duty for a financial manager role. The need for financial managers is growing at a faster than average rate compared to other occupations: 19 percent from 2016 to 2026, according to the Occupational Outlook Handbook.5
Each business has inherent risks, and an online MBA can help business leaders improve their understanding of how to deal with any risks they may face. Learn more about the finance electives you can take in the online MBA program at the University of Kansas.
1. Retrieved on September 1, 2018, from www.bls.gov/bdm/us_age_naics_00_table7.txt
2. Retrieved on September 1, 2018, from experian.com/small-business/business-credit-risk.jsp
3. Retrieved on September 1, 2018, from valuepenguin.com/average-small-business-loan-amount
4. Retrieved on September 1, 2018, from public.websteronline.com/business/business-interest-rate-risk-management
5. Retrieved on September 1, 2018, from www.bls.gov/ooh/management/financial-managers.htm