The Important Role of Financial Risk Management
Financial risk management is not contemporary. It has risen because of the increase in global markets and their instability. Changes in global markets occur instantaneously which lead to risks with managing finances. Hence the concept of Financial Management has become a basic best practice, to ensure mitigation of unforeseen losses.
Definition of Financial Risk
Risk means the possibility of loss due to exposure to certain circumstances. In any financial investment, there is a chance that the actual return will be much lesser than expected. This chance is referred to as Financial Risk. Managing this risk to minimize financial losses is the best practice known as Financial Risk Management.
The relationship between risk and returns is such that; the greater the amount of risk, the greater the possibility of greater return. This is because, the greater the risk and investor takes, the more there will be compensation for taking the risk.
As a best practice, many companies spend a lot of time and money on developing risk management strategies. These strategies help them in managing the risks associated with their investments. The key component of risk management is risk assessment. Risk assessment means determining the risks surrounding a business or investment through the following processes:
- Quantitative Risk Management: This is a best practice which uses mathematical calculations. These help in detecting, appraising and monitoring financial risks in any financial transaction. There are different versions of risk, and they are measured by mathematical evaluation. These calculations involve calculating the standard deviation of returns of the investment. It could involve either historical returns or average returns.
- Risk and Control Assessment: Managers prepare a risk and control self assessment RCSA report as a best practice. This report documents internal controls, risks and rates in categories of low, medium and high. The report provides corrective measure which can be taken to mitigate the risks. At the same time, it helps in ensuring best practices in Generally Accepted Auditing Standards.
- Insurance Coverage: This is an important best practice which prevents significant losses in both market and credit transaction. When it comes to international transactions between business partners this best practice is very important.
- Financial Risk Audit: It is a best practice for the internal audit department to perform periodic reviews on controls and policies. This ensures that the controls are adequate and functioning correctly. The financial risk auditor ensures that the accounting and reporting system is complete and working with accuracy. The tools involved are balance sheet, statement of profit and loss, statement of cash flow and statement of retained earnings.
Hence, financial risk management is an essential best practice which minimizes losses through implementation of controls and compliance.
Further reading: Corporate Governance | Audit | Performance Improvement