A ‘Sensitivity to Risk Analysis’ involves determining the likely impact that different risks may have upon the profitability of the business. There are various ways of undertaking such an analysis. Whatever way you choose is going to require some educated guess work.
Example of a Risk Analysis
Step 1. Identify threats to the business for example:
• Production Risks
Produce quality or quantity is affected by something (eg. weather, pests, disease, labour supply problems, materials supply, interruptions to power, flood etc.) Loss of orders through production delays.
• Financial Risks
Funds to operate the business become tight creating liquidity problems, interest rates change, stock market crashes, property values change (changing equity), production costs increase (eg. price increase on materials or labour).
• Marketing Risks
Selling prices fluctuate, exchange rate varies (important for export sales); terms of trade decline (eg. payments not made until months after sale), demand and supply vary (ie. unpredictable demand, lack of demand, inability to supply); damage to the business’s reputation in the market.
• Management Risks
Making decisions based on incorrect or poor information; your technological capabilities are lower than the competition thereby increasing your costs as compared to theirs; personnel fluctuations; potential mergers etc.; changes in partnerships.
• Personal Risks
Something goes wrong in the personal life of the business owner or employees (eg. health, family or social relationships, business succession - new generation taking control of family business).
• Political Risk
Changes to legislation; hold-ups on approvals ie. licences, permits etc; environmental restrictions, changes to the tax system, international influence etc.
• Other Risks
Analysis of possible threats is important and should be comprehensive – it is easy to overlook potential threats. To help overcome this it is best to list all possible risks and arrange the list in order of most likely to least likely. A spread sheet is a useful tool to help facilitate this. In order to include all possible threats go through each system, structure or organisation, department etc. within the business, look for vulnerability and analyse and list the risk for each area.
Step 2. Estimate Risk
Step one enabled you to identify threats and therefore risk to the business.
To help determine the probability of risk and the extent to which realised risk may impact on the business the following three questions are helpful:
• What is the best case scenario?
• What is the worst case scenario?
• What is the most likely scenario?
Some risk managers use the following equation to obtain a value for risk: multiply the probability of risk by the cost of the realised risk.
Another example: calculate the effect on net profit if there is a specified shift in the exchange rate with an export market.
If exchange rate drops 5%, determine the financial affect upon different components of the budget such as income, interest rate payments, living expenses, consumables (ie. petrol, etc), insurance, etc.
Step 3. Managing Risk
The cost of rectifying or eliminating a risk should not be more then the cost occurred should the risk eventuate.
Ways to manage risk:
- Use existing assets – improve existing methods to production and other systems; change employee responsibilities; improve supervision techniques and other internal control systems; improve accountability.
- Develop contingency plans – once all risk is identified you may decide that some risk is acceptable. A contingency plan gives you the means to take immediate action (with minimum management controls at the time) and this helps to minimise risk should the event be realised.
- Invest in new resources – in step 2 you will have determined which risk is acceptable and which is not. This information will help to determine whether investment in further resources to counter the risk is worthwhile.
- Alternatively you may spread the risk by insuring against it – this way the insurance company accepts part of the risk for you. For example by investing money into insurance to cover a crop or stock, you basically end up gambling on the event of a disaster. Should this disaster occur, and if it falls under the categories of the insurance, the farmer will be paid out according to the insurance. Insurances usually only exist for the duration of the particular crops or stock. Although not cheap when first looked at, the financial benefit in the case of a disaster is life saving for the farmer.
Premiums and risk are based on probabilities and as most farms do not insure their commodities/crops/heard and disasters do not occur regularly, there are few pay outs. Disasters normally considered for coverage include: fire, flood, catastrophe (for crops this would include hail, storm etc). Other topics covered by insurance are normal business expenses such as accident, workers’ compensation, income (ie. if your normal income stops then you are paid a specified amount for the specified time).
- Investing in other business - If all of your assets are in one business, for example a farm, and the farm fails to return an income or provide adequate cash flow; you will have no income at all. If you have "some" of your assets invested outside of the farm; you can continue to receive an income to some degree; even in poor seasons.
- Looking to the future - investing some of the yearly profit into a set saving system; similar to a superannuation or pension fund is one way to preserve some of the yearly profit. This normally cannot be cashed in and used until designated time of retirement. Unfortunately this locking away of money has been of no help in the past, but recent alterations to the laws in some countries, people under severe financial difficulty have been permitted access to the money.
- Diversify to spread risk - for example a farmer who diversifies into beef and ostriches plus fibre plants will still get income from the ostriches in severe drought, when the other two have failed. In another year a disease could break out with the cattle leaving the farmer to finance his farm on the back of ostriches and plant fibre. This also evens out the short term cash flow. Diversification allows the business to rely on more than one product, thus supporting it through times of market fluctuation. Deciding what you are going to sell is one of the most important business decisions you will make.
Diversification advantages:
Step 4. Review Risk
Regular reviews are useful tools to ensure currency for example – systems may change slowly over time and new risk may be introduced.
- Provides a buffer against financial catastrophe if one of the product fails.
- Averaging profits and loss over the different products.
- Two products or services may be combined for value adding (eg. vegetables and herbs, gardening/design etc.).
Example of a Simple Contingency Plan
Contingency planning involves preparing "escape routes"; to use in the event of something going wrong. This is done to reduce risk.
1st - Identify the areas of greatest risk.
2nd - Devise procedures to deal with identified problems, in the event that they might occur.
3rd - Prepare for implementing these procedures, if you need to use them. This might involve training staff or buying in equipment.
Example: A contingency plan to deal with fire:
1. Identify location of fire and items/persons at risk.
2. Clean combustible materials away from work areas, residences, stables, fence lines and other structures. Clearly mark safe exit zones and keep these as clear thoroughfares. Have a fire proof safe or store unit for business records or other non-replaceable items.
3. Train staff in fire prevention and control measures. Train staff in use of fire control equipment, and fire burn first aid. Maintain operational fire extinguishers that are checked according to specifications.
Check all fire fighting equipment monthly. Start motors weekly.