How Much Risk Should You Be Taking In The Business?
Risk will reduce value, but no risk, no reward.
Wouldn’t life be boring if there were no risks in our lives?
There is a certain amount of risk that is desirable. It’s possible that humans need a certain amount of risk in our lives to keep us mentally and physically healthy. Some people get that from risking their lives in the service of others like soldiers or policemen. Some get it by experiencing nature climbing Mt. Everett or swimming with sharks. And some get it from engaging in risky behavior like stealing from banks or dealing drugs.
From a business perspective, risk seems tame.
Risk in the financial or investment world is defined as: the measurable possibility of losing or not gaining value. This is differentiated from uncertainty, which is not measurable.
To Avoid Risk … But no…
One way to try to avoid risk from a financial perspective might be: Have no debt. Keep plenty of money in cash or cash equivalent investments so you can access cash whenever you need it. Guess what? That fluffy pile of cash is not earning a return much more than the money buried in the backyard. Wasn’t there a Bible story about the servant who didn’t put the money he was given to work to get a return?
How about this list of risks? Orange highlights are those generally seen in landscaping companies.
Actuarial risk – insurance underwriters’ risk covered in the event of death
Exchange risk – loss on foreign currencies
Inflation risk – chance that the value of assets or income will be eroded as inflation reduces a currency’s value
Interest rate risk – possibility that a fixed rate debt instrument will decline in value because of interest rate changes
Inventory risk– price changes, obsolescence, or other factors will shrink an inventory’s value
Liquidity risk – possibility that an investor can’t buy or sell a security in sufficient quantities or fast enough
Political risk – nationalization or other government action
Repayment (credit) risk – chance that a borrower can’t pay debt or obligation as promised
Principal risk – chance that invested capital will drop in value
Underwriting risk – risk taken by an investment bank that securities offered for sale won’t be purchased
Systemic risk – a risk that affects an entire industry. COVID-19 impacted some industries like hospitality and restaurants more than others.
The more financial or investment risk that an investor is exposed to, the more return that investor will expect for dollars invested.
Also, the more business your company is exposed to (especially if not covered by any insurance) will reduce your company’s value to an investor since the investor will expect a higher return for a riskier business. These may include:
Environmental risks – your yard or handling of chemicals may be contaminated
Human resource risks – many types of these exist, but have any of your employees created a hostile work environment, or set up a sexual harassment exposure?
Financial risk – in a quality of earnings review, will your books and records properly reflect all dollars that should be billed and collected? Do you have systems in place to independently check your accounting entries?
In the long run, it’s a balancing act. A smart business owner will reduce the type and number of risks he can control, but not try to eliminate all risk. If the owner did that, the result might be no company at all. The savvy owner will assess risks and balance the number of resources needed for future growth compared to the expected return that can be achieved.
Are you and your managers assessing your company’s risks and planning how you will deploy your resources to achieve maximum profitability? Great. Having the information, you need to optimize your company’s value is the first step. Have you been wondering what other steps a smart owner can take now to prepare for an exit from the company while achieving his/her goals? We will be happy to have a confidential complimentary conversation with you.
You can reach me via email: [email protected] or on my cell phone a: 224-688-8838.
We’re here to help you Harvest Your Potential!