What is Risk Management and Why Is It Important

What is Risk Management and Why Is It Important

What is Risk Management and Why Is It Important

Like everything else in life, running a small business comes with risks. As a business owner, there’s a non-zero chance you’ll have to deal with challenges like damaged equipment, market fluctuations, employee theft, unforeseen pandemics, or personal emergencies. 

The good news is you don’t have to be helpless against these unpredictable circumstances. In fact, you can lessen the impact by planning ahead with risk management. Let’s take a closer look at how risk identification works, and the practical steps you can take to implement a risk management program.

What is Risk Management?

The SBA boils this down to “minimizing the effects of risks on your business.” Their definition of “risk” is divided into two types of risk: internal and external. 

Internal risks occur within your business. Examples include:

  • Illness or death of an employee or business owner
  • Theft or fraud committed by employees
  • Low employee motivation
  • Malfunctioning equipment that requires maintenance and repair
  • Insufficient cash flow caused by either daily operations or business expansion opportunities

External risks come from outside your business. Examples include:

  • Broader market changes and increased competition
  • Increasing rent or healthcare costs
  • Legal and regulatory changes by the government or financial institutions
  • Changes in the needs of your target demographic
  • Damages caused by natural disasters and climate change
  • Cybersecurity threats

Effective risk assessment helps you plan ahead for these situations so you can minimize the potential impact on your business and stakeholders if and when they happen.

Why is Risk Management Important?

Poor risk management can result in unwanted financial, emotional, and even legal consequences. 

For example, imagine a hypothetical scenario where you run out of cash flow. Suddenly, your once thriving business grinds to a halt. You’re no longer able to open that new brick and mortar location you’ve been dreaming about. You’re also no longer able to pay your employees or your rent, and it won’t be long until you’re forced to default on your debts.

A good risk management plan can greatly reduce the chances of this happening. In this scenario, that could mean implementing accounting practices, or working with a bookkeeper to plan your cash flow months in advance. We’ll talk more about risk reduction strategies later on. 

The Risk Management Process

We’ve compiled a simplified version of the SBA’s risk management framework below.

Step 1: Identify Your Business’ Risks

The best way to identify risks is to write down everything that could potentially affect your profit. 

For effective risk management, the SBA recommends paying special attention to the following factors:

  • Excessive debt-to-equity ratio. In general, a debt-to-equity ratio above 40% is considered high and may negatively impact your finances. Note: this number can vary according to your industry, so be sure to compare before making any decisions.
  • Dependence on a small number of customers, products, and vendors. If this is true for your business, even a minor change in market or supply chain conditions could leave you with no alternatives.
  • Poor cash flow management. A positive cash flow is a good sign. But frequent overdrafts could be a red flag for your finances.
  • Accounting and IT risks. The SBA recommends auditing your bookkeeping and information technology systems. This helps ensure payroll is being properly accounted for, and only current employees have access to your systems.
  • High employee turnover rate. If your business has trouble with employee retention, it may make it tough to execute your goals.

The best way to identify your business’ potential risks is to create a business plan, which forces you to think thoroughly about these factors.

Step 2: Evaluate Your Business’ Risks

The next step is to perform a risk analysis of your business operations. 

The best way to do this is by exploring the consequences of each risk. For example, assume you’ve identified employee theft as a risk. This could hurt your inventory, which would raise your expenses as you replenish stock. In turn, this could leave you with fewer funds to pursue new business opportunities.

The SBA recommends doing an honest strengths, weaknesses, opportunities, and threats (SWOT) analysis for the most thorough results.

Step 3: Measure Your Business’ Risks

After evaluating your risks, consider how they could impact your cash flow and profit. 

One way to do this is by estimating expenses for each risk. For example, if you’ve realized your business relies on one vendor for your inventory, calculate the financial and operational risks of your vendor going out of business. Estimate how much it would cost to find a new vendor, as well as the opportunity cost of lost sales during that time period.

Step 4: Implement Processes to Minimize Risks

Create controls and contingency plans for each of your risks. Ask yourself: “If plan A falls through, what is my plan B?”

For example, if your business relies on the internet, and the WiFi goes out, your contingency plan may be to always have a functioning backup router in your storage room.

The SBA recommends creating a comprehensive business continuity plan that includes important contact info, staff members’ duties and work locations, and an employee notification hierarchy for who to notify in case of an emergency.

They also recommend asking your vendors about their business continuity plans to help you better plan ahead.

Another way to minimize your risks is to build emergency capital. Two solid tools are small business loans and business credit cards. Both give you access to funds you can use to keep your operations running smoothly and you cash flow steady during hard times.

Step 5: Create an Exit Strategy

Finally, create a worst case scenario plan. 

Sometimes, situations can fall beyond repair, and your business may be nearing the end of its lifecycle. Preparing an exit strategy can protect yourself from further emotional and financial risk. 

The SBA recommends accounting for these factors:

  • Sufficient funds for liquidating your assets without additional insurance
  • Sufficient provisions for insurance and asset liquidation in the event of your death
  • Any necessary disability benefits

Benefits and Challenges of Risk Management

The benefits of managing risk are clear. It protects your cash flow and assets when events arise, helping you operate with less financial and emotional stress. In turn, this makes it easier to achieve your business objectives. It may also give you a leg up against competition that doesn’t practice good risk management.

That said, mitigating risk can be easier said than done. You may not know exactly how to measure your risks, or evaluate which risks to prioritize. Your ego may prevent you from accepting certain situations as legitimate risks. And even if you do create a thorough risk management plan, it may be expensive to maintain the audits and controls necessary to make it effective.

Don’t be afraid to get help from experts that specialize in risk mitigation. The cost of hiring a consultant now could sharpen your decision-making and save you exponentially more money down the road. 

Nav can also help support your business’ risk management planning. We make it easy to find the best business insurance company for your business, so you can minimize the financial impact of worst case scenarios. Create an account to compare plans instantly.

How to Create a Risk Management Plan for Your Business

In summary, the best way to create a risk management plan and mitigate your identified risks is by following the five steps of the risk management process:

  • Identify your risks
  • Evaluate your risks
  • Measure your risks
  • Implement processes to minimize risks
  • Create an exit strategy

As mentioned earlier, creating a business plan is the best way to think through each of these steps on your own.

Then, once you’ve created a complete plan, consider hiring an expert service to help identify any blindspots. A fresh set of eyes can pinpoint risks you may not have realized were possible.

Creating backup plans for worst case scenarios may not be the most exciting exercise, but it can significantly increase your business’ long term success. And that makes it worth the effort.

This article was originally written on April 22, 2022 and updated on April 24, 2022.

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