MEvery entrepreneur tends to think that business is about taking risks. This is not a wise philosophy and can mean nothing but danger and pain. Today we will try to understand exactly what risk is and how an entrepreneur should approach its understanding and management.
What is risk? From a business perspective, risk is simply the probability, or call it the probability, that an undesirable event will occur out of a range of possibilities. But beyond that probability of occurrence, the size of the adverse consequences of the adverse event is another factor that is important to understand the risk and to identify, classify and manage it. For example, for management purposes, there is “no risk” when an undesirable event is unlikely or there are no undesirable consequences even if the event does occur.
Short-term transactions, medium-term projects and long-term deals involve all sorts of risks. Some risks have no undesirable consequences or only minor consequences that shouldn’t bother us. We can live with these risks. But many other risks can seriously affect or even threaten transactions, projects, or the growth or survival of our businesses. We must understand these risks and take action to mitigate them.
The importance of effective risk management: Smart risk management improves the overall effectiveness of business processes, thereby producing outcomes that protect and enhance the organization’s chances of survival and growth.
When we manage risk well in our organizations, we are able to protect transactions, identify projects in trouble, take proactive action, and avoid catastrophic events. We improve communication within the organization and our teams focus. Effective risk management reduces operational waste and improves our service delivery, revenue, cash flow and profitability. This creates trust in the company among all stakeholders such as employees, customers, lenders and suppliers. All of this will make the business more stable and resilient, thereby improving the chances for further growth.
Types of risks: There are different types of risk depending on your operating environment, industry, business model, business size, location, etc. Sometimes even the specific time and period within which a transaction is to be completed may entail particular risks. In general, however, there are two types of risk, internal and external.
Internal risks are those risks that you may be exposed to or could even materialize due to your company’s internal weaknesses. Internal risks include:
• Operational risk: This is the risk of loss resulting from inadequate or weak internal systems and processes. Operational risks could lead to other spin-off internal risks.
• Equipment Risks: When you run a manufacturing facility, you run the risk of old equipment breaking down, which can lead to downtime, lost supplies, and so on. In a service company, you can rely heavily on your computers and data. Malfunctions and failures in the systems can spell disaster.
• Human Risks: These are business risks that can arise from your employees not performing essential tasks. They could also be caused by fraudulent acts of sabotage by your people. Other human risks may include illness, injury, resignation of key personnel, etc.
• Financial Risk: Financial risk refers to the potential adverse effects of certain events on the flow of cash in and out of your organization. Cost increases, delayed debt collection, etc. can result in a company’s cash flows not being sufficient to continue operations and/or meet its contractual obligations.
Typically, internal risks are easier to mitigate because they are almost entirely under your control. However, it should also be noted that the emergence of one risk could trigger the likelihood of another. For example, if your equipment isn’t producing enough product, you may not be able to generate enough revenue, increasing your financial risks.
External risks, on the other hand, are risks that can arise from the occurrence of external threats. They include:
• Political Risks: Depending on the nature of your business, political risks can severely impact your operations. This happens, for example, with changes of government in developing countries, even if the changes are democratic.
• Market Risks: Market events can be volatile. You may not achieve the sales volume that you forecast. You may also not be able to sell your products at the prices you forecast. Any of these risks that could decrease the value of your stock is a market risk.
• Environmental hazards: Floods, fires, etc. due to environmental factors beyond our direct control can cause damage and loss to our businesses. Depending on what we do, we need to be aware of such risks and take preventive measures.
• Government and Regulatory Risks: These are the risks that a change in laws and regulations will significantly and adversely affect your business, industry or market. Changes in regulations can increase a company’s operating costs. On the other hand, it can also serve as an incentive for potential competitors to get involved and thereby change the competitive landscape.
There are much more specific risks that can impact your business, as illustrated in the scheme below. This may include compliance risk, legal risk, security risk, credit risk, cybersecurity risk, reputational risk, strategy risk, project risk, innovation risk, country or location risk, exchange rate risk, interest rate risk, seasonal risk, etc. Understanding risks is key to managing them.
What is risk management? Risk management refers to the conscious processes of identifying and recognizing risks and developing methods to accept, mitigate or manage them. This process includes:
• Risk assessment
• Risk assessment (and prioritization)
• Reaction development
Today we introduced what risk is, the importance of risk management and the types of risk. Next week we will continue with the components of risk management mentioned above.