What is financial risk?

Financial risk is the possibility of suffering monetary loss through a business venture or an investment. Some common examples of financial risks include operational risk, liquidity risk or credit risk.

Financial risk can be described as a type of danger leading to the loss of capital for the interested parties. For governments, this can imply that they cannot control default on bonds, monetary policies and other debt issues.

For corporations, it could imply facing a possibility of incurring default or debt that they have undertaken or experiencing a failure in the operations that could lead to a financial burden on the organisation.

KEY TAKEAWAYS

• Financial risk relates a circumstance to the odds of losing money.
• Financial risk describes where a company’s cash flow will be inadequate or insufficient to meet its obligations.
• Financial risk can also apply to government bodies that default on their bonds.
• Some common financial risks include currency, equity, foreign investment, asset-based, liquidity, and credit risk.
• Investors can utilise a variety of financial risk ratios to calculate a company’s prospects.

Types of risks

Depending upon the structure of your business, you can face various risks. Your financial risk can also enhance when the industry-specific business cycle suffers significant economic contractions, such as seasonal changes or temporary trends.

Some examples of financial risks include credit risk, liquidity and leverage risk, foreign investment risk and any risk related to your cash flow, such as when your customers are not paying their invoices.

Managing financial risks in construction projects

Payments work in unique ways in construction projects, and many forces could enhance financial risk. The nature of the business is credit-heavy, and the lack of visibility into who is doing what work and the high number of businesses involved in a single project make payment issues dubious for all involved parties. Parties at the top, such as property owners, lenders, and general contractors and parties at the bottom, such as equipment lessers, material suppliers or subcontractors, are all unsure of the payment chain.

If you are experiencing non-payment or late payment for your construction, remember that you are not alone. Keep reading the following article to understand what makes construction payments so complicated and how delays can be avoided.

Construction’s problem of assigning financial risk

When a construction project is taking place, most companies involved in the project both extend credit and need to borrow money. Instead of making payment up-front before performing work or delivering materials, most labour is furnished in exchange for payment promises.

If we use a non-technical term, it is very similar to the children’s game of “I-O-U.” The unsaid understanding is that all labour and materials supplied will get paid later. This understanding passes from the general contractor to the supplier and the subcontractor.

It is also true that the value of the materials or labour supplied on credit is substantially significant, often worth billions of dollars.

There is no exception to this credit-based payment scheme that extends every payment chain in every project, thereby substantiating the need to extend credit and borrow money for every company.

Businesses often have to wait to receive payment before paying their bills. Similarly, top management and big organisations are also awaiting payment for the work that they have already completed.

This structure of financial risk prevalent in a construction project increases the proportion of financial risk from the top of the chain to its very bottom.

Moreover, there are many cracks in the money chain for money to easily slip through and many a time; payments get delayed because of these deficiencies.

Additionally, as the payment chain is interconnected, any minor inconvenience, dispute or delay can potentially impact the payment for everyone on the project, whether directly or indirectly involved in the situation. This domino effect cannot be separated from construction projects.

Furthermore, this chaotic environment makes companies prioritise their choices regarding which invoices should be paid on time. The companies waiting for payments from higher parties may not have substantial cash to float around the invoices they receive.

Shifting financial risk in construction

Parties that are higher up on the payment chain or the contracting chain are generally the ones that can exert leverage over the payment process.

The reason behind this leverage is that money has to pass through fewer hands to get to these parties, and there is a lesser chance of the money becoming diluted or stuck. However, these top-of-the-chain parties are not isolated from their difficulties and financial risks.

One of the biggest problems that top-of-the-chain parties face is the problem of visibility. This is associated with the risk of mechanics where the top-of-the-chain parties are further removed from the general contractor. A general contractor cannot control the flow of money and has no way to ensure that the supplier is paid.

As a direct consequence of these prevalent concerns, top-of-the-chain parties have created contractual provisions specifically designed to shift financial risk away from them and make it a burden for others. When contracts are created, they are filled with risk-shifting clauses that seem ambiguous and nearly ubiquitous. A great example of such clauses is pay-if-paid/pay-when-paid clauses.

Pay-if-paid/pay-when-paid clauses are so well-known and accepted within the industry that no one seems to point out how odd the practice is. Courts often look at these clauses with disfavour, leaving parties to decide.

Taking the example of the United States, the general public policy has long been. It continues to be that majority of the financial risk will lie on the parties that are the closest to the money. This policy forces top management to be responsible. Mechanics liens can be filed to force top management to make the payments.

A mechanics lien is another statutory security interest commonly used in construction project contracts to define the actual property being improved by the project. Nearly every construction or renovation project person has the right to file a mechanics lien.

However, to prevent being taken advantage of, top-of-the-chain parties and property owners adhere to certain requirements and take specific actions to retain the right to file a lien. Examples of these requirements include sending specific notices and meeting deadlines when these requirements are met, and the allocations of risk shift to other parties.

As nobody wants to bear the burden of financial risks, top-of-the-chain parties have started to utilise other methods to chip away at the risk of lien on the project.

One prominent example is lien waivers. The purpose of lien waivers is to remove the lien risk, as payments are handed out throughout the project. A waiver is a receipt that is produced in exchange for a payment.

Nowadays, some property owners also include a “no-lien” provision in the contract to mitigate this risk entirely.

To succeed in reducing financial risks, organizations and companies should use whs software and injury management software in the workplace.

The right tools to reduce financial risk

Construction projects’ complex and complicated nature can make payments messy, but the financial risk can be reduced with the right tools. Some examples of such tools include legal documents and provisions. Examples of provisions include mechanics lien, notices, and waivers.

Some companies also utilise technological tools such as software applications to manage payment processes, lien waivers and lien compliance. The proper utilisation of these tools protects the top-of-chain parties from double payment and bottom-tier parties from late payment or non-payment. Fair practises are required for all construction projects to be successful and for all parties to get timely payment.

We suggest you also read the article ” What Is People Management ?”.