How To Minimize Business Risk To Maximize Value
Fundamentally, business risk is exposure to any factor that may cause a company to lose profits or to face bankruptcy. Unfortunately, business risk has many different faces and can be unpredictable. Additionally, each industry may have their own unique risks that are not seen elsewhere.
The total level of business risk may be influenced by many factors and sources. For instance, consumer preferences and demand, competition, the overall economy, government regulation, and management structure may present different levels of business risk. However, these only represent a few factors and instances that may influence the overall level of risk. Therefore, it’s important to speak with an advisor who can help you identify your specific risks and assist you in developing a plan that will minimize your level of risk.
This article will take a closer look at identifying and quantifying business risks. Take a look and give me a call at 614.923.6569 if you have any questions.
Quantifying Risk
In addition to identifying specific risks and factors, you may want to calculate your company’s sensitivity to certain issues. Your company’s contribution margin and degree of operating leverage, for example, are easy to calculate and will shed light on your business’s sensitivity to change.
Contribution Margin
Contribution margin represents the amount of revenue your product, or service, contributes to covering your company’s fixed costs. It is calculated as follows:
Contribution margin = sales revenue – variable costs; OR (for a percentage)
Contribution margin = (sales revenue – variable costs) / sales revenue
It can be used, for example, to help determine an appropriate prince range for your product or service and find your expected profit level. It is considered a key component to break-even analysis.
Degree of Operating Leverage
The degree of operating leverage (DOL) measures the sensitivity of your company’s operating income to changes in sales. There are several ways to measure this multiple:
DOL = percent change in EBIT / percent change in sales; OR
DOL = change in operating income / change in sales; OR
DOL = contribution margin / operating income
Assuming all other variables remain constant when calculating this multiple, the higher the DOL, the more sensitive your operating income is. This multiple can be used to predict and forecast the impact that possible risks and events could have on your operating income.
Categories of Business Risk
As previously mentioned, there are many different factors and sources that could affect the level of risk your company may face. Likewise, there are numerous types of business risk that are influenced by these factors. Such risks are: compliance risk, operational risk, strategic risk, reputational risk, and security risk. Let’s look at these types of risks a little closer.
Compliance Risk
You’ll find compliance risk within industries that are heavily regulated by the federal, state, or local government. It is important to be aware of all applicable laws and regulations that could impact your business as heavy fines could be imposed. Being timely and accurate with the government would help reduce this risk.
Operational Risk
Operational risk typically occurs internally, but may also be influenced by external factors. Sources of operational risk include inefficient employees and equipment failures. Having appropriate training and equipment check-ups could help reduce this risk.
Strategic Risk
Strategic risk is found when your company begins to operate outside of its business plan or model. As your company continues to operate this way, its strategy will become less effective, ultimately causing goals to be missed. This risk can be mitigated through careful consideration of new projects, ventures, and policies that may not align with your business model.
Reputational Risk
Reputational risk arises from the public’s view of your business. Any topic such as lawsuits, scandals, environmental concerns, poor customer service, and faulty products, can cause your company’s reputation to diminish. This would subsequently weaken your customer base and bottom line. Focusing on public relations, high-quality products, and friendly customer service, for instance, will strengthen your reputation and lower this risk.
Security Risk
Security risk is becoming a higher concern to the public and management alike. This risk arises from computer hacking and data breaches. If your system is compromised, your clients’, suppliers’, and business partners’ information could be at risk, severally impacting your reputation. Financial information and trade secrets can also be stolen, weakening your competitive advantage. To mitigate this risk, computer safety must be emphasized. This includes employee training, malware protection, usage of VPN’s, and changing passwords regularly.
How Is Your Business At Risk?
While this is not an all-inclusive account of the business risks you may be facing now or in the future, it does provide you with an overview of the more commonplace risks. It is important for the vitality of your business to be aware of these various risks and how best to manage them.
How can Rea & Associates help with reducing risk? The valuation and transaction advisory team offers profit enhancement services that are designed to put your business’s risk front and center in order to identify steps you can take to drive you business’s overall value. By taking a closer look at your people, policies, processes, and business operations, the team can identify your unique business risks and then quantify how each factor impacts your overall value and determine a game plan to reduce or eliminate each risk.
When you better understand the various risks that are out there and where your business stands, you gain the knowledge and insight necessary to increase your profits and, ultimately, make your business more valuable. If you, or someone you know, requires a business valuation for estate, gift, litigation, merger and acquisition, or business planning purposes, please contact Rea & Associates to learn more about our services.
By Duncan Copeland, valuation and transaction advisory services (Dublin office)
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