One of the traits of developing a successful business is having contingency plans in place for risks that you may face. Insufficient planning can lead to profit loss and even permanent closure. In this article, we’ll define and explain the different types of business risk. Here’s what you need to know.
What is business risk?
Business risks are factors that threaten and inhibit the overall operation of your business which in turn prevents it from achieving its targets and financial goals. Numerous sources contribute to the risk; they may be internal, external or a combination of both such as poorly managed policies and procedures as well as the overall state of the economic climate.
Business red flags
Market risk, also known as systematic risk, affects the whole performance of a business. Sources of market risk include recessions, changes in interest rates, political instability and natural disasters.
Amid the coronavirus pandemic, businesses in many sectors are struggling and maybe looking to for a cash injection from potential investors. If this is the case, it’s essential that you can prove effective incident-protection strategies are ready to be implemented; a lack of planning is a massive red flag and will deter investors quickly.
Many start-ups and SMEs need to take out a business loan to fund start-up and necessary operational costs such as rent of office space, purchasing of material and equipment, set up of internet as well as other IT solutions. As a business entity, you are obligated to pay the lending institution (e.g. a bank) an agreed-upon amount every month. This means that you must have sufficient cash flow to budget for this expense. If you are unable to pay (default) on the loan, compound interest will accumulate, increasing the amount you owe.
Credit risk is calculated according to the five Cs: credit history, capacity to repay, capital, the loan’s conditions, and associated collateral. If your business is considered to be a high credit risk, it’s possible that you won’t qualify for a loan in the future, or you may have to use a subprime lender that charges inflated interest rates. It’s vital that you are able to manage credit correctly. This means having enough cash flow to pay creditors. The consequences of defaulting can be dire and liquidation, business rescue
Liquidity is your business’s ability to repay its debts without suffering significant losses. Potential investors will utilise liquidity measurement ratios when analysing the level of risk of a business – the result will determine whether an investment is worthwhile. They’ll usually compare your business’s liquid assets and short-term liabilities. Liquid assets include but are not limited to cash or cash-equivalent assets; these comprise of stocks, bonds, and mutual funds. They are considered cash-equivalent assets because they generally won’t lose value when sold.
Liabilities are usually a sum of money that a company owes to creditors such as loans, accounts payable and other accrued expenses. It’s critical to understand liabilities because they are used to finance operations of the business.
Businesses will sort their liabilities into two categories: current and long-term. Current liabilities are classed as debts that are payable within one year; whereas, long-term liabilities are debts payable over a longer time horizon. An investor will ideally want to see that a business can pay current liabilities in cash and long-term liabilities paid with assets accumulated from future earnings.
Operational risk is viewed as any hazards or ambiguities that can hinder the daily activities of a business. This can be caused by internal factors such as poor policies and procedures (an example may be poor maintenance of equipment and IT systems. Something as simple as not checking the stability of your internet connection can cause havoc if it’s not working properly); or, external influences, which in South Africa, can include load shedding of electricity, economic events that contribute to market risk.
To mitigate operational risk, it’s a good idea to consult HR experts to ensure that you have effective, clear internal policies and procedures instituted so that human error is minimised.
Cash flow is the net amount of cash (and cash-equivalent liquid assets) that are transferred in – and out – of a business. A business’s ability to generate positive cash flows creates value, which is a factor that will encourage investors to put their money into the business.
There are three forms of cash flow: operating, investing, and financing.
- Operating cash flow is all money that is generated from the business’s daily activities.
- Investing cash flow includes but is not limited to purchasing of capital assets and other investments.
- Financing cash flow comprises of all money gained from issuing debt, equity as well as all payments made by the business.
Prospective investors will also be looking at the business’s ability to maximise free cash flow (FCF) which is the cash that a business can produce after it has accounted for cash needed to sustain daily operation and maintain capital assets. Essentially, free cash flow is a measure of profitability that excludes any non-cash expenses but includes spending on equipment, assets as well as any changes in working capital (which is the difference between your current assets and current liabilities.)
Steps needed to create a risk management plan
All businesses need a risk management plan. Here are the primary steps that you need to take.
Find out the risks that are most likely to occur. It would be best if you also determined which risks will cause significant disruption and minor disruption.
Once these risks have been identified, they need to be analysed by financial planning specialists who can help develop strategies that will minimise or eliminate the risks.
Planning for risk response
A specific contingency plan needs to be developed according to the size and type (sector-specific) of your business because certain risks will be more prevalent than others. Therefore, the plan needs to be customised to address those risks effectively.
All the types of risk that have been identified should be continually monitored to ensure your business can run as smoothly as possible.
At fio.life, our independent financial advisers we understand your needs and wants, giving you peace of mind that your business is strategically prepared for all relevant risk factors. You can focus on building your brand and driving revenue growth to achieve your financial goals. We also have a Business Consulting division if you’d like to book a video conference call.