European Journal of Business and Management www.iiste.org ISSN 2222-1905 (Paper) ISSN 2222-2839 (Online) Vol.6, No.5, 2014 97 The Impact of Financial Risks on the Firms’ Performance Jamal A. Mohamed Noor, Ali I. Abdalla Jomo Kenyatta University of Agriculture, Department of Business and Commerce, Kenya Abstract Firms are exposed to a variety of risks including credit risk, liquidity risk, foreign exchange risk, market risk and interest rate risk. An efficient risk management system is needed in time in order to control these risks. Managing risk is one of the basic tasks to be done, once it has been identified and known. The risk and return are directly related to each other, which means that increasing one will subsequently increase the other and vice versa. Financial risks have a great impact on firm’s performance. The study also assessed the current risk management practices of the firms and linked them with the firms’ financial performance. The findings confirm whether financial risks can be contained or managed in order for firms to achieve profit maximization for its shareholders. Keywords: Financial Risk; Firm’s Performance; Interest rate parity; Liquidity gap; Liquidity risk; Risk Management. 1.0 Introduction 1.1 Background of study Risk is defined as anything that can create hindrances in the way of achievement of certain objectives. It can be because of either internal factors or external factors, depending upon the type of risk that exists within a particular situation. Managing risk is one of the basic tasks to be done, once it has been identified and known. The risk and return are directly related to each other, which means that increasing one will subsequently increase the other and vice versa. And, effective risk management leads to more balanced trade-off between risk and reward, to realize a better position in the future (Fatemi and Fooladi, 2006). Globalization and internationalization has increased the risk of firms in the developing countries. This is due to competition from within and outside the countries by either directly from other or indirectly through access to International trade. Management of financial risks has been a big concern for investors, analysts, managers and shareholders around the world. The Kenyan economy is becoming more and more open with international trading constantly increasing and as a result the Kenyan firms become more exposed to foreign exchange rate fluctuations. Exchange rate changes can lead to changes in the relative prices of the firm’s inputs and outputs. The relative price changes can affect the firms competitive market position, leading to changes in cash flows and, ultimately, in firms value. While it can be observed that firms in developed economies use a variety of instruments to manage financial risks, it is not clear whether the full potential of these instruments is being realized in developing economies notably Kenya since not all firms use derivatives and not all firms use all types and more important, whether they are used appropriately (Njoroge et al., 2013). Profitability is the most common measure of firm performance. The measures of profitability are used to assess how well management is investing the firms' total capital and raising funds. Profitability is generally the most important to the firm’s total shareholders. Profits serve as cushion against adverse conditions such as losses on loans, or losses caused by unexpected changes in interest rates (Gitogo et al., 2013).The primary measure of firm performance is Tobin's Q Which refers to the ratio of the total asset minus market value of common equity plus the book value of equity to the book value of assets. If Q index calculated for company is greater than one , there will be high motivation for investment, namely, a high Q ratio is usually a sign of the company's investment and growth opportunities worth; if Q ratio is less than one the investment should be stopped. Also alternative measures of firm performance such as return on equity (ROE) and return on asset (ROA) will be used. ROE is operating income scaled by the market value of equity and ROA is net income scaled by total assets (Choi et al., 2013). 1.2 Objective of the study 1.2.1 General Objectives The main objective of this study was to analyze effects of financial risks to firm’s performance. 1.2.2 Specific Objectives i) The find out how credit risk affect firms’ performance ii) To find out how liquidity risk affect firm’s performance iii) Determine the effects of market risk to firm’s performance iv) To analyze the how foreign exchange rate risk affect firm’s performance