Small business owners take risks every day. But if you put too much at stake, your business bottom line could suffer. To make sure your decisions are sound, conduct a risk analysis for your small business.
What is a risk analysis in business?
A risk is a situation that can either have huge benefits or cause serious damage to a small business’s financial health. Sometimes a risk can result in the closure of a business. Before taking risks at your business, you should conduct a risk analysis.
A risk assessment for small business is a strategy that measures the potential outcomes of a risk. The assessment helps you make smart business decisions and avoid financial issues.
Jason Olsen, serial entrepreneur and founder of Studios 360, Prestman Auto, and Automobia, explained in his article:
The key is to not only use optimism for reasons to take action, but also to utilize risk factors you uncover to guide your decisions. Yes, you must have courage to bet on your ideas, but you must also have the ability to take a thoughtful, calculated approach. It’s nearly impossible to remove all risk in any scenario, but what’s important is to make sure these troublesome areas are always considered and understood.”
Internal vs. external risks
Usually, a risk is either internal or external. Internal risks occur inside of your operations, while external risks occur outside of your business.
Internal risks are often more specific to your business and easier to control than external risks. Examples of internal risks include:
- Financial risks
- Marketing risks
- Operational risks
- Workforce risks
Though you can project external risks, they are usually out of your control. You might need to take a reactive approach to managing external risks. These risks include:
- Changing economy
- New competitors
- Natural disasters
- Government regulations
- Consumer demand changes
How to do a risk assessment
There is no one way to assess business risk. The assessment is not 100% accurate when it comes to judging your level of risk. A small business risk analysis gives you a picture of the possible outcomes your business decisions could have. Use the following steps to do a financial risk assessment.
Step 1: Identify risks
The first step to managing business risks is to identify what situations pose a risk to your finances. Consider the damage a risk could have on your business. Then, think about your goals and the rewards that could come out of taking the risk. Depending on your business, location, and industry, risks will vary.
Step 2: Document risks
Once you have a list of potential business risks, define them in a document. Develop a process to weigh the effect of each risk. Look at how much damage the risk could potentially cause and how hard it would be to recover. Set up a scoring system for risks, from mild to severe.
Step 3: Appoint monitors
Identify individuals at your business who will keep an eye on and manage risks. The risk monitor might be you, a partner, or an employee. Decide how risks should be reported and handled. When you have procedures for risk management, issues can be taken care of smoothly.
Step 4: Determine controls
After understanding potential risks, figure out controls you can use to reduce them. Look at patterns over time to predict your income cycle. And, assess the impact risks have on your business. Look at the significance of a risk as well as its likelihood of occurring at your business.
Step 5: Review periodically
Your business risk assessment is not a one-time commitment. Review risk management processes annually to see how you handle risks. Also, look out for new risks that might not have been relevant in the previous assessment.
Use a risk ratio to gauge risk
A risk ratio shows the relationship between your business’s debts and equity. Business debt creates risk. By comparing debt, or leverage, to equity, you get a better understanding of your business’s level of risk. This can help you set more targeted business debt management goals.
Debt-to-equity ratio
There are different kinds of financial leverage ratios. One common leverage ratio formula is the debt-to-equity ratio. For this ratio, divide your total debt by your total equity. Business equity is equal to your assets minus liabilities and shows your ownership in the business.
Debt-to-Equity Ratio = Total Debt / Total Equity
For example, you have $30,000 in debt and $15,000 in equity.
$30,000 / $15,000 = 2 times or 200%
This means for every dollar you have, you owe two dollars to creditors.
By finding the debt-to-equity ratio, you can see how much capital comes from debt. The more debt you have compared to equity, the bigger your risk level.
Purpose of risk assessments
Risk assessments are an important part of running your business. You can use your business risk assessment for making decisions and financing your business.
A simple risk analysis will help you avoid hazards that could damage your finances. The assessment informs you about the steps you need to take to protect your business. You can see what situations you need to address and avoid.
Beyond internal use, a financial risk assessment can help you prepare to talk with lenders. These individuals want to know your business’s level of risk before giving you money. They look at the likelihood of your business growing and how likely you are to pay back the loan.
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This article is updated from its original publication date of May 9, 2017.
This is not intended as legal advice; for more information, please click here.