Many entrepreneurs tend to think that business ‘is about taking risk’. This is not a wise philosophy and may spell nothing but danger and pains. 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 likelihood of an undesired event happening out of a number of possibilities. But beyond the likelihood of occurrence, the magnitude of unwanted consequence of the undesired event is another factor that is important in understanding risk and identifying, classifying and managing it. For instance, for managerial purposes there is ‘no risk’ if an undesired event is unlikely to occur or there is no unwanted consequence even if the event does occur.
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Short-term transactions, medium-term projects and long-term businesses come with all sorts of risks. Some risks have zero unwanted or only little consequences that shouldn’t bother us. We can live with those risks. But many other risks can severely hurt or even threaten transactions, projects or the growth or survival of our businesses. We must understand those risks and take actions to mitigate them.
The importance of effective risk management: Wise risk management improves overall effectiveness of business processes, thereby achieving results that protect and enhance the chances of business survival and growth.
When we manage risks well in our businesses, we are able to protect transactions, detect projects in trouble, take proactive actions and avoid catastrophic events. We improve communications within the organisation and our teams get focussed. Effective risk management reduces operational wastes and enhances our service delivery, revenues, cash flows and profitability. This engenders confidence in the business from all stakeholders, such as employees, customers, creditors and suppliers. All these will make business more stable and resilient, thereby improving the chances of further growth.
Types of risks: There are different types of risks, depending on your operating environment, industry, business model, business scale, location, etc. Sometimes even the specific timing and period within which a transaction is to be conducted may pose peculiar risks. Generally speaking, however, there are two types of risks, the internal and the external.
Internal risks are those risks that you may face or could even crystalise because of the internal weaknesses of your business. Internal risks include:
• Operational Risks: These are the risk of loss arising from inadequate or weak internal systems and processes. Operational risks could lead to other spinoff internal risks.
• Equipment risks: If you are running a manufacturing facility, you run the risk of old equipment failing, thereby resulting in downtimes, missed deliveries, etc. In a service business, you may rely a lot on your computers and data. Glitches and failures in the systems could spell disaster.
• Human risks: These are risks in business, which can arise as a result of the failure of your people to perform essentials tasks. They could also arise as a result of the fraudulent acts of sabotage by your people. Other human risks may include illness, injuries, resignation of key staff, etc.
• Financial risks: Financial risks refer to the possible unwanted effects of certain events on the flow of money in and out of your business. Increase in costs, delayed collection of receivables, etc. may lead to a business’ cash flows not being sufficient to keep operations running and/or discharge its contractual obligations.
Typically, internal risks are easier to mitigate because they are almost entirely within your control. But it should also be noted that the crystallisation of one risk could trigger the likelihood of another. For instance, if your equipment fails to produce enough products, you may not be able to generate enough sales, thereby increasing your finance risks.
External risks, on the other hand, are risks that might crystallise as a result of the occurrence of external threats. They include:
• Political risks: Depending on your type of business, political risks can greatly affect your operations. This, for instance, happens when there are changes in government in developing countries even if the changes are democratic.
• Market risks: Happenings in the marketplace can be volatile. You may not make the volume of sales you projected to make. You may also not be able to sell your products at the prices you projected. Any of such risks that could lower the value of your stock is a market risk.
• Environmental hazards: Flood, fire, etc. due to environmental factors outside our immediate control can cause damages and losses to our businesses. Depending specifically on what we do, we have to be alert to such risks and take preventative measures.
• Government and regulatory risks: This are the risks that a change in laws and regulations will materially and negatively impact your business, sector or market. Changes in regulations can increase the costs of operating a business. It may, on the other hand, also serve as an incentive for potential competitors to come in thereby changing the competitive landscape.
There are a lot more specific risks that can impact on your business as shown in the schematic below. These may include compliance risks, legal risks, security risks, credit risks, cybersecurity risks, reputational risks, strategy risk, project risk, innovation risk, country or location risk, exchange rate risk, interest rate risk, seasonal risks, etc. Understanding risks is key to managing them.
What is risk management? Risk management refers to the deliberate processes of identifying and recognising risks, as well as developing methods to accept, mitigate or manage them. This process involves:
• Risk identification
• Risk assessment (and prioritisation)
• Response development
Today we have introduced what risk is, the importance of risk management and types of risks. Next week, we will continue with the components of risk management, mentioned above.
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