A business financial risk assessment is the process you use to identify potential risks and find the best ways to respond to them. Whether you’re a startup or in your growth stage, you’ll want to conduct regular financial risk assessments to make smart decisions and avoid financial disasters.
Let’s define “risk” before we move on to definitions, processes, and analysis specifics.
What is risk? It’s an action that you could take, an action that would benefit your business, but could also damage your business. You take a risk when you look at the factors and determine whether the action is likely to help or harm the company.
What happens when small businesses don’t know how to identify financial risk?
An entertainment business is tasked with catering, managing, and directing ticket sales for a large festival. The revenue figures are incredible. There’s exposure nationwide. It’s televised. If all goes well, this entertainment business is expected to earn twice what it did in the previous year in just two months.
However, to make the time to do the work and cover the cost of materials, perishables, and payroll to generate that revenue and exposure, the business would have to drop three-quarters of its clients. Cash flow would stop. Spending would skyrocket. The old clients are gone.
This would be a risk. The consequences are known. The rewards are known. What is not exactly known is whether it will rain or the owner of the festival will decide to breach the contract. Still, there are a finite number of situations that could lead to a negative outcome. Do the owners have a history of violating contracts? What’s the weather report looking like? If we know what can ruin us, then we’re dealing with risk. How we move from there is a matter of judgment and risk tolerance.
Risk assessments happen every day.
A business risk assessment forces you to ask yourself a few questions:
- What could go wrong?
- How likely is that to happen?
- What would it cost?
- And how can we prevent such a thing from happening?
They show you where your business is weak to changes in factors like inflation, interest rates, or regulations. A quality assessment does more than tell you what could go wrong; it gives you answers for how to proceed.
There are five types of financial risk.
‘Risk’ is a broad term. There are a lot of different risks out there. Before you get started, you should know how to break down the various risks you’ll encounter.
Market risk is the potential for losses from the markets.
This category is also called systematic risk because it involves large-scale, external factors that can impact your business. Changes in the interest rate, consumer behavior, or new technology are a few examples of market risk.
Credit risk occurs when customers buy on credit.
Any time you extend a line of credit to customers, you open yourself up to potential losses.
When customers don’t pay, you’ll face disrupted cash flow and reduced revenue. In some industries, that’s just standard operating procedure, but you should still be aware of the risk.
Liquidity risk involves your ability to convert assets to cash.
In certain situations, your business needs to quickly liquidate its assets. If you run into short-term obligations and can’t produce cash, you’ll run into trouble. That’s why it’s important not to have too many of your resources tied up in assets that can’t easily be liquidated.
Operational risk means the potential for business operations to fail.
Lawsuits and personnel issues are an unfortunate, if rare, part of running a business. Operational risk covers the potential for these kinds of events to occur. You should be prepared for operational failures that occur as part of normal business operations.
Currency risk arises from changes in exchange rates.
This type of risk is more of a concern for businesses that engage in international trade or operate in foreign markets. Exchange rates are always going to fluctuate, but a big swing can be devastating for certain international businesses.
Use this four-step guide to assess financial risk.
A financial risk assessment is about more than knowing the risks you’re facing; it’s about learning how to respond to those risks. Here’s our four-step guide to creating a business risk assessment.
Step 1: Identify the risks.
Look at internal factors like your operations and strategic goals. Then move to external factors, like market forces, customer behavior, and regulatory changes.
The goal is to identify all significant risks, so there’s no set number here. Typically, businesses will come up with 10 or 15 risks, depending on the size of your business. You don’t want so many that you can’t engage with them substantively.
Step 2: Analyze the risks.
Now that you’ve got your risks, you should dig into them. Evaluate the likelihood of each risk causing problems for your business.
Give each risk a likelihood of low, medium, or high (or 1-10 if you prefer). Then estimate the cost if a worst-case scenario were to occur. This way, you can prioritize the most likely or damaging financial risks to your business.
Step 3: Create a plan to identify financial risk and prevent it.
Some kinds of risk can be prevented. You can use several internal controls to protect your assets.
- Internal control #1: Use regular audits to catch errors early and keep your records accurate.
- Internal control #2: Have a robust approval process for significant transactions, so that no major financial decisions are made without oversight.
- Internal control #3: Segregate duties to prevent fraud. For example, have different employees responsible for cash handling and accounting.
A plan can also mitigate the damage of external risks.
Some risks are unavoidable, but you can take steps to reduce harm. It’s a good idea to diversify your revenue streams, giving your business the flexibility to respond quickly. You should also always have three to six months’ worth of operating expenses on hand in case of an emergency.
Step 4: Monitor the risks.
Review your financial risk assessment throughout the year for changes and conduct a new one around every 12 months.
You should also be prepared to adjust the deadline if your business undergoes a significant shift.
Here’s a sample strategic objective and its risks.
Let’s say your business has set a new strategic objective: increase revenue by 10% over the next year.
You’ll need a plan to achieve that objective, but also internal controls to manage the risks associated with it.
Create your plan for growth.
To achieve your revenue goal, start by identifying key areas where growth is possible. This could include proactive steps like
- expanding into new markets,
- launching a product, or
- increase your marketing budget to reach different customers.
You may instead decide to focus on streamlining and reducing unnecessary costs. Whichever strategy you choose, set milestones to track progress. Then, adjust as needed.
Sharpen your internal controls.
I’ve covered internal controls broadly. Now, let’s focus on specific actions you can take as you attempt 10% revenue growth.
- Keep a close eye on outstanding accounts to prevent unpaid debts from piling up.
- Have an approval process in place if you’re rolling out a new marketing strategy or discount.
I highly recommend looking into automated financial tracking systems to stay on top of cash flow and expenses; this is a tried-and-true method to identify financial risk factors before those factors become business problems.
Use software to enhance your risk management.
Programs like Pirani can streamline the process of creating and maintaining risk assessments. However, software can’t replace the expertise brought by someone like an on-demand CFO, who can interpret the data and develop a strategy tailored to your goals.
Risk is involved in most significant decisions, so let’s make sure we know all the factors and be proactive in the decision-making process.
You may still have specific questions or need guidance on identifying financial risk in alternative scenarios. Fortunately, those questions will be addressed if you build a financial risk assessment that’s right for your business. If this makes sense for your business, we should talk. Schedule a discovery call to start.
Talk soon,
Jeremy A. Johnson, CPA