What is risk management and why is it important

Like everything else in life, running a small business involves risk. As a business owner, there is a non-zero chance that you will face challenges such as damaged equipment, market fluctuations, employee thefts, unforeseen pandemics or personal emergencies.

The good news is that you don’t have to be helpless in the face of these unpredictable circumstances. In fact, you can reduce the impact by planning ahead for 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 summarizes this as “minimizing the effects of risk 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
  • Defective equipment requiring maintenance and repair
  • Insufficient cash flow caused either by daily operations or business expansion opportunities

External risks come from outside your business. Examples include:

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

An effective risk assessment helps you plan for these situations in advance so you can minimize the potential impact on your business and your stakeholders if and when they occur.

Why is risk management important?

Poor risk management can lead to unwanted financial, emotional, and even legal consequences.

For example, imagine a hypothetical scenario where you run out of cash. Suddenly your once thriving business comes to a halt. You are no longer able to open that new brick and mortar location you’ve been dreaming of. You are also no longer able to pay your employees or your rent, and you will soon be forced to default on your debts.

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

The risk management process

We have compiled a simplified version of the SBA Risk Management Framework below.

Step 1: Identify your business risks

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

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

  • Excessive debt ratio. In general, a debt ratio above 40% is considered high and can have a negative impact on your finances. Note: This number may vary depending on your industry, so be sure to compare before making a decision.
  • Dependence on a small number of customers, products and suppliers. If this is true for your business, even a minor change in market or supply chain conditions could leave you with no alternative.
  • Poor cash 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 accounting and information technology systems. This ensures that payroll is properly accounted for and that only current employees have access to your systems.
  • High employee turnover rate. If your business has employee retention issues, it can be difficult to achieve your goals.

The best way to identify potential risks in your business is to create a business plan, which requires you to think carefully about these factors.

Step 2: Assess your business risks

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

The best way to do this is to explore the consequences of each risk. For example, suppose you have identified employee theft as a risk. This could hurt your inventory, which would increase your expenses as you replenish your stock. In turn, this could leave you with less funds to pursue new business opportunities.

The SBA recommends doing an honest Strengths, Weaknesses, Opportunities, and Threats (SWOT) analysis for the most in-depth results.

Step 3: Measure your business risk

After assessing your risks, think about the impact they could have on your cash flow and profits.

One way to do this is to estimate the expenses for each risk. For example, if you have realized that your business depends on a single supplier for your inventory, calculate the financial and operational risks associated with the bankruptcy of your supplier. Estimate how much it would cost to find a new supplier, as well as the opportunity cost of lost sales during that time.

Step 4: Implement processes to minimize risk

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

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

The SBA recommends creating a comprehensive business continuity plan that includes important contact information, job duties, and locations of staff members, as well as an employee notification hierarchy that outlines who to notify in the event of an emergency.

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

Another way to minimize your risk is to build up 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 your cash flow stable during tough times.

Step 5: Create an exit strategy

Finally, create a worst case scenario plan.

Sometimes situations can become irreparable and your business is approaching the end of its life cycle. Preparing an exit strategy can protect you from other emotional and financial risks.

The SBA recommends considering these factors:

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

Benefits and Challenges of Risk Management

The benefits of risk management are clear. It protects your cash flow and assets when events occur, helping you operate with less financial and emotional stress. In turn, this makes it easier to achieve your business goals. It can also give you a leg up against competitors who don’t practice good risk management.

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

Don’t be afraid to seek help from experts who 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 you plan your business risk management. We make it easy to find the best commercial 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 to follow the five steps of the risk management process:

  • Identify your risks
  • Assess your risks
  • Measure your risks
  • Put processes in place to minimize risk
  • 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 comprehensive plan, consider hiring an expert service to help you identify blind spots. A fresh look can identify risks that you might not have realized were possible.

Creating backup plans for worst-case scenarios might not be the most exciting exercise, but it can dramatically increase the long-term success of your business. And it’s worth it.

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

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