In these quickly changing markets, how can you be sure that your business has adequate risk management strategies? With so many mid-size businesses failing, both before and after the pandemic, you might be wondering how their risk management strategies didn’t seem to work at all.
I’ll let you in on a little secret when calculating business risks – the key is to calculate your risk based on where your profits come from. Keep reading to learn everything you need to know about risk management while keeping your profits in mind.
What is calculated risk in business?
In business, calculated risk is known as “a carefully considered decision that exposes a person to a degree of personal and financial risk that is counterbalanced by a reasonable possibility of benefit.”
On the way to building a business, every business owner has assumed some sort of risk, whether it’s taking out a loan or hiring a new employee. As your business grows, you’ll constantly have to assess risk, even as your business gets off the ground. So, how can you tell if a risk will be worth it?
Many factors go into risk management, including your business finances, profits, specific calculations, and your industry expertise and skills. When you take all of these factors into consideration, you can make good decisions about business risks.
What are the different types of business risk?
As I mentioned previously, owning and operating a business always requires some level of risk – it doesn’t matter if you are just starting out or have been in business for several years. Different kinds of business risks include financial risks, reputation risks, operational risks, compliance risks, and fraud risks. Risk management takes all of these factors into consideration.
How can I measure risk?
There are several ways to measure risk. One of the most common risk management measurement methods is standard deviation, which calculates the dispersion of results from the expected value. Another standard measuring tool is the Sharpe ratio, measuring the return on an investment in relation to its risk. While there are many options for measuring risk, let’s dive deeper into how to calculate risk with profits in mind.
The importance of putting profits first
Many companies use a risk heat map to assess their level of risk. These maps examine massive risks like natural disasters or smaller ones like sales force effectiveness. Unfortunately, risk heat maps don’t consider all of the granular factors, especially risks that threaten profitability in today’s fast-changing markets.
Simply put, a risk heat map is a mapping of the risk magnitude of various business elements. The likelihood of problems is on one axis, and the element’s importance is on the other. These maps don’t consider details like where the majority of profits come from, which customers are spending the most money, and which products are the most lucrative.
Instead of using a risk heat map to assess risk, businesses need to integrate their key, profit-generating customers, products, and operations into their risk management process. But how exactly should entrepreneurs and business owners start doing this?
Transaction-based profit metrics are a great place to start. When business owners begin to use transaction-based profit metrics and analytics, it’s easy for them to see that their customers generally fall into one of three categories:
- Profit peaks: these are high-revenue, high-profit clients. Usually, these are the 20% of customers that generate 150% of the profits.
- Profit drains: these are high-revenue, low-profit customers. Typically, these are the 30% of your clients that can erode 50% of your earnings.
- Profit deserts: these are low-revenue, low-profit clients that consume 50% of the company’s resources.
Once you realize that 20% of your customers generate 150% of your profits, the most critical risk management factor is to protect and grow these profit peaks. Then, you can examine your profit drains to determine if their losses are growing or diminishing. If the losses are growing, it’s important to implement risk mitigation measures to reverse the growth or potentially reprice these relationships. You’ll also realize that risk factors affecting your profit deserts are insignificant to your overall profit unless they impact large numbers of customers.
Analyzing your risk based on these three factors is a better way of determining the right decisions for your company. Calculating your risk with these factors in mind makes risk assessment more manageable, actionable, and comprehensive.
Using a profit contour
Rather than using a risk heat map, it’s better to use a profit heat map. The best way to configure this image is through a “profit contour.” This matrix includes the customer profit segments on the vertical axis and the product profit segments on the horizontal axis.
It’s simple to create similar profit contours for important combinations, like products and stores, or sales representatives and customers. Through a profit contour, you can identify risk factors that endanger the protection and growth of profit peaks, which can then immediately be mitigated.
Different ways to calculate risk management
In addition to using a profit contour, there are three other common ways to measure business risk with profit in mind. Each of these methods is used to track potential value changes within a period of time.
Earnings at Risk (EAR)
Earnings at risk is the change in net income resulting from interest rate changes over a specific time period. EAR can help risk professionals and investors understand how changing interest rates can impact a company’s finances and cash flow.
This calculation involves balance sheet items known to be sensitive to changes in interest rates and generate income or cash flow. Here’s an example: a bank may have 90% confidence that the gap in expected earnings due to interest rate changes will not exceed a certain amount of money through a given period. This example is known as its earnings of risk.
Value at Risk (VAR)
Value at risk deals with a company’s total value. This measures the overall change in value over a specific amount of time with a certain degree of confidence. VAR calculates the financial risk correlated with the total value of the business. This calculation is much broader and more generalized than figuring out how interest rates impact cash flow. VAR measures the maximum potential loss over a specified time period.
Here’s an example of VAR: a company has a 5% one-year value at a risk of $10 million. In other words, there is a 5% chance that the business could lose over $10 million in a year. You could also look at it like this: there is 95% confidence that the firm will not lose $10 million in a year.
Economic Value of Equity (EVE)
The economic value of equity is mostly used in the banking world. This model measures the amount that a bank’s total capital could change due to interest rate fluctuations. EVE differs from VAR and EAR in that a bank uses the value of equity measure to manage its liabilities and assets. This cash flow calculation subtracts the present value of expected cash flows on liabilities from the current value of expected cash flows.
Other Common Formulas for Risk Calculation
Contribution Margin Ratio
This ratio is the contribution margin as a percentage of total sales. The contribution margin ratio is calculated as sales minus variable costs. Here’s how you can calculate the contribution margin ratio:
- (Net Sales Revenue – Variable Costs) / (Sales Revenue)
Degree of Operating Leverage
Also known as the DOL, the degree of operating leverage is a financial efficiency ratio measuring if a company’s variable or fixed costs are higher. A low DOL implies that a business’s variable costs are larger than its fixed costs, and a high DOL means that fixed costs are higher than variable costs. With high variable costs, a significant increase in sales will not lead to much of an increase in operating income.
Here’s the formula for the degree of operating leverage:
- DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
- DOL = % Change in Operating Income / % Change in Sales
- Contribution Margin / Operating Income
Degree of Financial Leverage
Simply put, the degree of financial leverage measures the amount of debt a business holds. A business’s debt creates additional risk to the company if income varies since debt must be serviced. No matter the revenue, a business must pay interest on the debt. You can calculate this formula in the equations below:
- DFL = % Change in Net Income / % Change in Earnings Before Interest and Taxes (EBIT)
- DFL = % Change in Earnings per Share (EPS) / % Change in EBIT
- DFL = EBIT / (EBIT – Interest)
If the ratio equals 1, then the business has no debt.
Degree of Total Leverage
The degree of total leverage, or DTL, calculates the number of unit sales that will affect the business’s net income or the net earnings per share. Here’s the formula:
- DTL = DOL x DFL
With this formula, you can also determine how much an increase in revenue can increase the earnings per share.
Among most of the businesses that I have conceived, partnered, or been in as purely an investor, most of those that raised OPM (Other People’s Money) crashed. You can easily see why when you fund any company, and just see where the money actually goes.
True, but not that funny, is an example of a company in Costa Rica – where I’d invested – which had weekly expenses $2000 for “Coke” which is too high for the said soda, and too low for the Pablo Escobar thing. As it turned out, it was a combo of both. Too many investors have had their money down the drain because of such wayward incidents and erratic founders.
Eventually, I came to the conclusion, that whatever new venture I put my time/resources into, would not have any outside funding or outside partners. It would be a one-man show – my mistakes would go in the wastepaper bin, and I would be responsible for the accolades and the brickbats. Even from me to me…
As it turns out, the reasoning was as good as gold, and I never look back. 5 people are enough to be that Unicorn that others shout from the damn rooftops about after garnering hundreds of millions in funding! Yes, I enter the riskiest businesses on the planet after months of research and planning and create that elusive Unicorn from scratch.
It’ll stay this way. For me.