How to Calculate Business Risk

Jupiterimages/Photos.com/Getty Images

Becoming an entrepreneur, whether a trucker, builder or merchandise company, requires taking risk. Thriving as an entrepreneur requires calculating risk and applying good risk management to minimize the worst threats. Risk management isn't one size fits all, as each individual business has its own unique set of challenges.

TL;DR (Too Long; Didn't Read)

To calculate business risk, list all potential risks. Evaluate the probability of them happening and how badly they'd hurt. Multiply probability by the level of damage to identify the risks that really pose a serious threat.

Internal and External Risk

There are many different approaches to classifying and calculating risk in business. One method of classifying risk is internal and external. Is the problem coming from inside your company or outside?

Internal risks include financial problems, marketing difficulties, operational risks and workforce risks. External risks include the risks of economic change, new competition, natural disaster, new regulation and consumer taste changing.

  • Financial risk includes problems such as a heavy debt load or the risk of having a negative cash flow if you don't get paid.

  • Operational risk includes the possibility of equipment breaking down.

  • Workforce risk includes hiring employees who don't measure up, key employees leaving or failing to keep employees motivated.

  • Marketing risk is the danger that you can't actually sell your products.

  • Economic change includes the possibility of recession or high unemployment affecting consumer demand. This is a particular problem if you're offering luxuries rather than essentials.

  • A classic example of new regulations would be the growing number of places where smoking is banned. That's a big disincentive for people to smoke.

The Risk Assessment Process

You can't make a business risk calculation until you identify the risks. While you may have plenty to deal with already, it's worth sitting down and identifying potential risks before they become serious threats.

  • What are the internal risks? Is your cash flow steady?  Is your marketing plan sound? Are employees motivated? Look ahead for potential problems. If you're asking your team to sacrifice, is there a point at which they'll give up?

  • What about external risks? Is the economy stable? Can you market new brands or services to keep up with changing consumer taste? Would it be easy for new companies to enter your industry and undercut you?

  • What do other people think? Your accountant has insight on financial risk, and your attorney has insight on the legal aspects. Ask for their input

Risk assessment is a process that is different for each business. A company on the coast of Florida doesn't have to worry about earthquakes, for instance, but global warming and hurricanes are serious issues.

Calculating Risk in Business

If you spot a potential risk, apply a business risk formula to figure out the danger. Calculating risk in business involves two factors: how likely the risk is to happen and how bad it will be if it does.

  • The probability risk assessment looks back at history. Is it the kind of risk that happens once in a century? Once in a decade? Once a year? More frequently than that?

  • The impact assessment looks at how badly your company will hurt if the risk becomes reality. This can be classified in levels of loss, such as under $1,000 to over $50,000. Alternatively, you can go with a non-financial measure ranging from insignificant damage to catastrophic.

  • Number both the probability and the impact from one at the lowest level to four or five at the top.

To make the business risk calculation, just multiply the numerical rankings. If you have a three for probability (it will happen every year) but a one for damage (it's insignificant), then it's a low-ranked three. If it's a two for probability (once a decade) but a four for catastrophic damage, that's a much higher, more serious eight.

Calculating Financial Risk

If the big risks are financial, it may be possible to measure them more precisely. The business world is overflowing with financial ratios for business risk calculation.

For example, the financial leverage formula measures the impact of loans, bonds and other debts you carry on your profitability. There are several ways to calculate this depending on the aspect of your finances about which you're worried.

Your contribution margin is the price minus all variable costs, showing the incremental profit on each unit sold. If you're contemplating cutting prices to beat the competition, the contribution margin shows how low you can go without losing money.

Dealing With Risk

Once you complete a risk assessment, you'll have an idea of which risks are the most troublesome. Some risks may be minor enough that they're not worth action. More serious threats require planning to avoid or to prevent the risk from occurring.

References

About the Author

Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com

Photo Credits

  • Jupiterimages/Photos.com/Getty Images