Understanding Financial Risk Management Tools

Introduction

Despite tremendous effort being made in forward-looking risk mitigation strategies, businesses remain vulnerable to market, liquidity, credit, legal, and regulatory risks. They need robust financial risk management tools, like enterprise risk management and derivatives, risk assessment models. However, traditional ways of putting these financial risk management tools into action are often not sufficient.

Treasurers frequently struggle with managing multiple systems, internal teams, banks, customer accounts, currencies, and compliance and tax laws to achieve effective results with these tools. Moreover, they have a hard time facilitating these tools across various departments. This is where AI-led advanced treasury and risk solutions come into play. They not only complement these traditional financial risk management tools but also ensure they are well-suited for various risk scenarios, facilitating the implementation of the formulated responses.

With this in mind, HighRadius’ Treasury and Risk Management suite brings automated solutions, such as cash positioning, debt and investment management, payment anomaly detection, and variance and scenario analysis to boost the effectiveness of financial risk management tools. This blog explores financial risk management tools in detail and explains how HighRadius’ Treasury and Risk offerings help businesses maximize the benefits of these tools.

What is Financial Risk And Financial Risk Management?

Financial risk refers to potential financial or monetary losses arising from poor cash management, inaccurate cash flow forecasting, payment errors, and poor borrowing or investment decisions. These result in inadequate capital, bad debts, cash flow concerns, and lower returns.

Financial risk examples include market fluctuations impacting stock prices, credit risks from loan defaults, liquidity problems that lead to non-payments of short-term debts and insufficient working capital, and operational inefficiencies like system failures impacting production and revenues.

To mitigate these financial risks, businesses need to have a robust financial risk management system in place. These systems help identify, measure, and manage potential risks. Financial risk management helps develop strategies to reduce exposure to financial risks by evaluating all possible remedies.

Types of financial risks

1. Credit risk: This arises when the business or a counterparty fails to fulfill its contractual obligations, leading to non-payment.
2. Market risk: These risks occur due to volatility or movements in market conditions. Changes in interest rates, equity prices, exchange rates, and commodity prices, are some of the elements of market risk.
3. Liquidity risk: This occurs when a business fails to settle its immediate or short-term liabilities and is unable to convert its assets into cash.
4. Operational risk: This occurs due to failures such as mismanagement, technical issues, inefficient internal processes, and ineffective systems.

What Are The Tools of Financial Risk Management?

Financial risk management tools encompass the systems and processes that a business implements to detect and quantify different financial risks. These tools typically include derivatives, diversification, credit risk management, liquidity risk management, enterprise risk management, capital adequacy planning, etc.

1. Risk assessment models for accurate forecasting

Risk assessment models help businesses quantify potential losses that occur due to market fluctuations. These tools use statistical models to analyze historical data and simulate various scenarios to evaluate the impact of market movements on financial assets and cash flow.

To complement these traditional risk assessment tools, HighRadius offers Machine Learning-powered Forecasts that are trained using historical data and heuristic models for accurate projections. The system leverages past transaction data, analyzes them, and picks the best-fit model with the highest accuracy from hundreds of permutations of models and parameters.

So, by leveraging both standard models and customized forecasting approaches, businesses can identify the optimal strategies and optimize the overall risk management framework.

2. Liquidity risk management

Liquidity risks occur when a company is unable to meet its short-term financial obligations. Liquidity risk management helps streamline a business’s cash flows and working capital and monitor the available reserves. Automated cash management solutions provide features like daily cash positioning and cash reconciliation that contribute to effective liquidity risk management.

Our cash management solution comes with daily cash positioning features that give 100% visibility into cash and bank accounts. It helps make funding decisions that best suit the liquidity needs of the company. Moreover, businesses can create unlimited cash position templates to analyze global cash visibility across various criteria such as company, bank account, banks, categories, region, countries, and dates, enabling proactive management of accounts with low balances.

Similarly, automated cash reconciliation features will help identify and handle unmatched bank transactions by either manual matching of transactions, creating offsetting transactions, or adjusting entries. This helps detect any discrepancies, errors, or fraud in payments that appear as unmatched transactions and maintains the integrity of cash balances. Both of these tools help businesses effectively reduce the risk of overdrafts, funding gaps, or unexpected cash shortages.

3. Credit risk management

Credit risk management involves techniques to assess and manage the risk of default. It could be businesses failing to meet vendor payments or customers not paying invoices. The tool includes methods like credit scoring models and credit derivatives that help build a structured approach to assessing creditworthiness and mitigating credit risk exposure. To help enhance credit risk management, businesses can use HighRadius’ advanced AI forecasting for accounts receivable (AR) and accounts payable (AP) and gain a granular understanding of cash flows relating to AR-AP.

These next-gen cash forecasting features are based on customer-specific AI models built to improve upon the Auto-ML accuracy rate for AR and AP categories by leveraging vendor invoice information, purchase order information, promises to pay, credit memos, and deductions. It also helps view expected cash flows and variance at the individual invoice levels so a business can evaluate the scope of non-payments and enable precise credit risk assessment.

In addition, businesses can also leverage credit line management to build structured frameworks to optimize credit risk exposure. They can enter credit line or facility information in their calculations to manage fees, drawdowns, and calculate borrowed limits, and available borrowing capacity. They can also implement automated alerts and triggers to monitor deviations from expected credit behaviors.

4. Diversification of investments

Businesses should avoid concentrating all investments in one place . Diversification of portfolios across different assets and markets not only helps reduce risk but also ensures better yields. To increase the effectiveness of diversification, businesses can use automated financial instrument management for both fixed and floating rates.

Businesses can use our automated instrument management to create, track, and manage Debt / Investment (D/I) instruments, such as bank loans, term loans, letters of credit, etc., in a single place, including intercompany loans or investments. It automatically generates cash flows related to D/I instruments and continuously pulls market holidays for every major financial center and currency worldwide to ensure accurate business day information, thereby reducing the impact of market volatility on returns.

5. Internal controls

It includes verifying compliance with policies, procedures, and internal audits to monitor and manage financial risks with operations and financial reporting. The hindrances to these regulatory compliances mostly occur due to errors and anomalies in transactions that go unnoticed.

Our automated treasury payment solutions, like payment anomalies, eliminate the risk of payment errors and fraud, ensuring sanction compliance. AI-driven fraud and anomaly detection identify suspicious payments, flagging anomalies, and self-learning from historical data, to adapt to new fraud patterns. It also provides enhanced protection through third-party partnerships. In addition, features like smart sanction screening flag payments for validation, comply with regulations to avoid fines, and block payments to listed entities by matching Office of Foreign Assets Control (OFAC) and client-subscribed sanctions lists.

6. Capital adequacy planning

It ensures that sufficient capital reserves are available to absorb potential losses and mitigate risks. The best way to streamline working capital reserves is to have complete visibility and control over cash and bank balances. Leveraging our automated features for bank connectivity helps businesses get real-time status and insights into cash balances across accounts, enabling them to seamlessly integrate with major banking systems. This provides a holistic view of transactions at any time. This further enables businesses to ensure that they have adequate reserves to fund operations.

7. Enterprise risk management (ERM)

It refers to a holistic approach that integrates all aspects of risk management across an organization. It helps businesses systematically analyze various internal and external factors posing threats and make informed decisions. It fosters a risk-aware organization that seamlessly navigates contingencies.

Tools for Quantifying Financial Risk

Various techniques and tools will help quantify financial risk. These mostly involve tools dealing with statistical analysis and forecasting methods.

1. Scenario analysis

Creating a ‘what-if’ analysis is the best way to identify and evaluate the possibility of financial risks. Our cash forecasting solutions offer AI-driven scenario builders to create what-if scenarios on top of a base forecast. The feature comes with a user-friendly interface that can change amounts, percentages, and timings of cash inflows and outflows, as well as the impact of foreign exchange rates.

The cherry on top is the forecast snapshot comparison feature. Businesses can save a version of scenarios at a point in time as a “snapshot.” They can access it at any time in the future, compare it with another snapshot side-by-side, and evaluate the differences that are highlighted in a visual heatmap.

2. Variance analysis

Businesses can compare actual numbers with forecast results to understand the reasons behind changes in numbers and identify gaps in their financial position that might have led to risks. Our thoughtfully designed variance analysis feature in cash forecasting allows businesses to view historical forecasts and analyze the variances from the actuals at the cash flow category level.

Additionally, businesses can also use a variance analysis matrix to drill down and understand the changes in variance over time. This allows users to make better borrowing and investment decisions and compare variances over time. For instance, the below matrix shows that the forecast for May 1st, 2024, varies between 10% and 2% for 30 days.

3. Regression analysis

It helps businesses understand how one variable is affected by changes in other aspects of the business. It usually highlights the impact of a range of factors on one significant metric and can be used to quantify the impact of various risks on financial performance.

To increase the effectiveness of regression analysis for mitigating risks, our cash forecasting solution offers LiveCube for cash forecasting. LiveCube is a no code, Excel like platform that helps businesses perform all complex arithmetic functions like regression analysis in no time with accuracy.

Businesses can also define the structure, formula, and model of cash flow categories for each cell. Moreover, the templates will also allow for manual adjustments when businesses want to track or take control of the version.

4. Value at Risk (VaR)

VaR helps businesses define the maximum loss they might face at a point in time. Businesses mostly use this method to determine losses due to risks faced at a confidential level.

Strategies To Implement Tools for Financial Risk Management

To implement these financial risk management tools, businesses need robust strategies. These strategies can either focus on mitigating with advanced risk measures, prevent risks by leveraging technology, transfer or adjust the risk for minimal impact, or accept the residual risk.

1. Identifying risks

Businesses must start by identifying potential risks that can affect their objectives and operations. It involves gaining a comprehensive understanding of internal and external factors using tools like internal controls, risk assessment models, and historical data.

2. Evaluating the financial risks

Businesses must evaluate the identified risks, determine their impact on operations, and ascertain the likelihood of their occurrence. This will help them understand the significance of risks and prioritize them based on their consequences.

3. Prioritize and quantify risks

Businesses have to prioritize risks to minimize their impact on business operations. They also need to quantify the risks in monetary terms, allocate resources effectively, and focus efforts on managing more complex risks.

4. Formulate risk responses

There is no one-size-fits-all strategy to handle financial risks. Businesses must formulate responses that best fit the situation. For instance, a company facing interest rate risk for an overseas investment, can consider diversifying its portfolio. Or, it can use interest rate derivatives to hedge against rate fluctuations. It can also avoid the risk by adjusting the duration of its assets and liabilities or maintaining enough liquidity buffers. Each response here is tailored to address all possible impacts of interest rate risk.

5. Implement and monitor risk responses

Businesses have to implement risk responses across departments and monitor them. They must ensure all units work in sync with each other to apply financial risk management strategies and increase their effectiveness and relevance.

Leverage HighRadius’ Treasury and Risk Suite To Increase Your Financial Risk Management Tools

HighRadius’ next-gen Treasury and Risk Suite understand the complications of financial risk management tools. It goes beyond implementing mere sophisticated technologies. Businesses need highly advanced, automated solutions that not only help businesses mitigate risk but also build a strong foundation for financial risk management.

Check out our cutting-edge Cash Forecasting and Cash Management software to streamline cash flows, detect unmatched cash transactions and inefficiencies, ensure effective cash positioning, and get a complete list of cash and bank balances across regions and accounts. All this will help businesses increase the effectiveness of their financial risk management down the line.

Also, businesses can increase the relevance of financial risk management by ensuring robust and accurate forecasting with auto-ML cash forecasting templates and quantifying the financial risks with the help of variance and scenario analysis. Further leveraging our treasury payment solutions will help detect payment anomalies, identify risk patterns, and deploy smart sanctions for secured financial transactions.

FAQs

1. How do you identify financial risks?

To identify financial risks, a business has to search for and outline all possible drivers that threaten financial stability. It will also analyze past data and industry trends to frame mitigation strategies. These risks can occur due to operational inefficiencies, market volatility, etc.

2. How do you handle financial risk?

Here are a few ways to handle financial risks:

• Create a cash management strategy
• Maintain emergency reserves
• Keep a lower accounts receivables
• Diversify investments
• Leverage advanced financial technology
• Evaluate operational efficiency
• Conduct scenario analysis
• Cover debts with insurance

3. How do companies manage their operational risk?

To manage operational risks, companies must do the following things:

• Anticipate the operational risks before they arise
• Continually evaluate cost and benefit situations
• Avoid risks that offer no real returns or rewards
• Lastly, delegate to top-level management for better strategic planning

4. What is financial risk management software?

Financial risk management software refers to a specialized solution designed to assist businesses in navigating and mitigating financial risks efficiently and effectively. It offers numerous features to quantify the impacts and build a strong foundation for financial risk management.

5. What are the financial risk mitigation mechanisms?

There are four financial risk mitigation mechanisms businesses can use: 

• Mitigating with advanced risk measures
• Avoiding using advanced technology to navigate high-risk activities
• Transferring or adjusting the risk for minimal impact 
• Accepting the residual risk by establishing reserves