Financial risk analysis in projects

Introduction

The purpose of projects goes beyond the execution of activities; it is oriented towards generating benefits such as income, which ultimately translates into profits for its owners and stakeholders. These projects represent a strategic bet in search of competitiveness and profitability opportunities in a dynamic business environment. However, the pursuit of success entails challenges, as projects face a series of financial risks that can impact their economic viability and expected results.

This article discusses financial risk analysis, its meaning, typology, and why it should be considered in the project stages, thus providing a comprehensive understanding of this critical variable for the success of a project.

Risks and projects

According to the Project Management Institute (PMI) cited by Toledo (2007), it is essential for project teams to develop risk management that identifies the factors impacting the project from the perspectives of cost, time, and scope and serves as the basis for developing a response plan. In this sense, Lifson and Shaifer (1982) cited by Martínez, Moreno, and Rubio (2012), agree with this view and specify that a project risk is an uncertain event or condition that, if it occurs, has a negative or positive effect on at least one of the project objectives, such as time, cost, or scope.

According to Lionel Galaway, as expressed in his publication “Quantitative Risk Analysis for Project Management: A critical review,” cited by Del Carpio (2006), project risk management is the art and science of identifying, analyzing, and responding to risks throughout the life of a project, with the purpose of achieving the project’s objectives.

In the world of project management, within the risks associated with costs, financial risk analysis plays a fundamental role in the planning and successful execution of any business initiative. Understanding and mitigating the financial risks associated with a project is essential to ensure economic viability and the achievement of established objectives.

From market volatility to fluctuations in interest rates, financial risks can have a significant impact on the profitability and overall success of a project due to the financial constraints associated with budgets.

What is financial risk analysis in a project?

The Banco Bilbao Vizcaya Argentaria BBVA (2024) describes financial risk as the uncertainty arising from the performance of an investment, due to changes in the sector in which it operates, the inability of one party to repay the capital, and the instability of financial markets.

In a project, this risk can be linked to the fluctuation and instability in cash flows, meaning not having the necessary resources to cover project expenses.

Therefore, it can be stated that financial risk analysis in projects refers to the process of identifying, assessing, and managing risks related to financial aspects that may affect the success of a business project. These risks may include uncertainty in expected revenues, fluctuations in costs, changes in economic conditions, among others. The main objective of financial risk analysis is to anticipate and mitigate potential negative impacts on the profitability and economic viability of the project.

Financial risk assessment is generally performed using techniques such as sensitivity analysis, scenario analysis, and probabilistic valuation. These methodologies allow project management teams to identify the most significant risks and develop appropriate financial risk mitigation strategies. It is important to note that financial risk analysis does not seek to completely eliminate risks but to manage them effectively to minimize their impact on the project.

By understanding and proactively managing financial risks, organizations can improve their decision-making capabilities and achieve their business objectives with greater confidence.

Types of financial risks in a project

Various types of financial risks can threaten the economic viability of a project, as indicated by articles from the European Business School CEUPE (2024) and BBVA (2024), which are outlined below:

• Market risk: Linked to fluctuations in market prices, such as those related to raw materials. Changes in these prices can directly impact production costs and, ultimately, the profitability of the project.
• Exchange rate risk: Arises when the project involves transactions in foreign currencies. Changes in exchange rates can affect the value of project revenues and costs, especially in cases of exports, imports, or foreign loans.
• Interest rate risk: Related to the financing cost of the project. Variations in interest rates can influence borrowing costs and, therefore, the profitability of the project.
• Inflation risk: Affects the purchasing power of project cash flows, especially regarding initial costs. Changes in input and service prices can erode expected profit margins.
• Liquidity risk: Refers to the difficulty of converting assets into cash when necessary. Although a project may have valuable assets, a lack of liquidity can hinder the fulfillment of financial commitments, jeopardizing its continuity and stability.

Financial risk management in project stages

Managing involves identifying, analyzing, evaluating, and mitigating financial risks from the initial stages of the project; all to ensure economic viability and long-term success. Additionally, addressing financial risks from the beginning helps avoid surprises in later stages of the project, such as delays, cost overruns, or even project failure. By understanding financial risks from the outset and developing suitable strategies, organizations can increase their chances of achieving project objectives within the established budget and timeframe.

Below is an overview of common financial risks at each stage of a project:

Initiation and planning phase

• Initial financing risks: Lack of capital to initiate the project can delay its start or compromise its economic viability from the outset.
• Cost estimation risks: Inaccurate estimates in the project’s initial costs can negatively affect the allocation of financial resources.
• Bond default risks: Reflects the possibility that, due to the absence of required bonds, the contractor or party responsible for the project may not meet established obligations, which could result in consequences such as loss of advance payment, legal penalties, or early contract termination, reputation loss. The contracting party is exposed to contractual breaches by the executor, execution delays.

Execution phase

• Cash flow availability risk: Not having the necessary liquidity, being imprecise in determining income and expenses according to the payment schedule.
• Cost fluctuation risks: During this phase, changes in the project scope, unexpected technical problems, or supply issues may arise, leading to increases in the projected costs of materials and labor.
• Budget control risks: Lack of adequate budget control can lead to significant deviations from the planned budget.

Monitoring and control phase

• Budget deviation risks: As the project progresses, unforeseen events may arise that result in deviations from the initially established budget.
• Deadline non-compliance risks: Project execution delays can increase associated costs, such as labor payments or equipment rentals.

Closing phase

• Inadequate settlement risks: Poor management in the closing phase can result in unexpected expenses or legal disputes that increase the final project costs.
• Post-implementation risks: After project completion, additional costs related to maintenance, updates, or warranties may arise, which were not considered during the initial planning.

Tactics for mitigating financial risks in projects

The project management team must apply tools that allow them to anticipate problems. In these forecasting exercises, questions like “what if” can be asked; this scenario simulation leads to identifying risks and future actions to be taken based on them. The activities for efficient risk management involve risk identification, qualitative analysis, formulation of response plans, and control and monitoring.

Decisions regarding risk treatment and strategies to implement can range from doing nothing to deepening the risk analysis, connections, impacts, and consequences; exercising controls; redefining operations or objectives, among others. It all depends on systematic, structured, comprehensive analyses based on cost-benefit relationships executed by the project management team.

A robust project management approach, including clear objective definition, establishment of a risk response plan, and proper resource allocation, is crucial for effectively addressing financial challenges. Additionally, close collaboration between the client and contractor, based on transparency and open communication, can significantly contribute to mitigating financial risks and ensuring the project’s economic viability. Ultimately, implementing financial risk mitigation strategies such as supplier diversification, insurance procurement, or contingency fund reserves, expediting payment and procurement processes, can help protect the project from potential financial losses and ensure its long-term success.

If you want to learn more about financial risks, check out the ebook from the Inter-American Development Bank (IDB) “Financial Risk Management: A Practical Approach for Latin American Countries.“

Conclusions

It is essential that when investing in project development, the ability to meet established commitments is evaluated. This involves applying effective control measures such as frequent financial reports, considering external conditions that may affect the project’s economic viability, estimating costs accurately, and preparing a risk management plan.

Financial risk analysis plays a crucial role in this process as it allows for the identification, evaluation, and treatment of different types of financial risks that may arise in the project. By understanding these risks and taking measures for financial risk mitigation, companies can increase their chances of success and minimize potential economic losses. The more information available about the risks, the better the decision-making in the project, leading to healthy financial management.

References

1. Banco Bilbao Vizcaya Argentaria BBVA (2024). What is financial risk? 5 tips to reduce it. https://www.bbva.com/es/salud-financiera/finanzas-para-todos-el-riesgo-financiero-y-sus-tipos/
2. Del Carpio Gallegos, J. (2006). Risk analysis in information technology project management. Industrial Data, 9(1), 104-107.
3. European Business School CEUPE (2024). How to conduct a financial risk analysis? https://www.ceupe.do/blog/como-hacer-un-analisis-de-riesgo-financiero.html
4. Martínez, G., Moreno, B., & Rubio, M. D. (2012). Risk management in engineering projects: The case of the university campus pts. University of Granada (Spain). Dyna, 79(173), 7-14.
5. Toledo, R., & Prado, O. (2007). Demystifying risk planning: A practical approach. Paper presented at PMI® Global Congress 2007—Latin America, Cancun, Mexico. Newtown Square, PA: Project Management Institute.