THE BLOG

Four Reasons Your Small Business Needs Risk Management

06/18/2012 07:07 pm ET | Updated Aug 18, 2012
  • Chitra Nawbatt Business Development and Financial Services Executive

As an entrepreneur, is risk management something you think about or even think applies to your business? What is risk management anyway?

Many large, medium and small companies spend a lot of time on risk management and have it embedded in their culture. This includes defining the components of risk, and developing frameworks and processes on how to identify, measure and manage risk. It is never too soon in the life of a small business to think about and address these elements.

Risk can be dissected in many ways. Four commonly defined categories are market, credit, operational and reputational risk. All of these areas can be rolled up into an enterprise wide risk management approach.

Market Risk

In larger companies or financial institutions, market risk is the risk that the value of your assets will decrease due to a change in the value of external factors. Some examples of this include changes in interest rates, foreign exchange rates and commodity prices.

Similarly from the lens of small business, we can think about the economic and environmental factors that impact our business. For example, if you have an import business where you import goods from Asia for resale in the US or other markets, you are subject to changes in international trade laws and regulation, foreign currency risk, availability of goods from suppliers and channels in Asia, etc.

Do you have a plan to identify and monitor the market influences that impact you? One may consider identifying and writing down those potential external influences on the business, and formulating a plan of how to address or mitigate unfavorable market forces.

Credit Risk

Credit risk is the risk of loss that occurs when a counterparty does not make payment on the debt that they owe you. For example, this can occur when your customer or vendor defaults on paying you as required per the transaction terms.

This happens all of the time and especially during challenging economic conditions. What is your risk management plan? Do you have the appropriate bad debts expense and loss provisions established from an accounting perspective?

A primary form of credit risk is the credit default risk or the risk that someone will not pay. There is also concentration risk which can occur when you have many transactions with one counterparty or group of similar counterparties, such as many customers in one particular industry.

Some measures to address some of these potential risks include using risk-based pricing, purchasing insurance if applicable and diversifying your customers or counterparties. Just as having diverse revenue streams is important, in the same way having diverse counterparties or customers is critical. You may want to monitor and be conscious of if you have too many transactions with a common denominator of counterparty, especially if the values at risk are material in your business context.

Operational Risk

Operational risk is the risk of loss from inadequate or failed internal processes, people and systems, as well as external events. Some specific sub categories of operational risk include internal and external fraud, employment practices, client and business practices, business continuity processes, etc.

Many companies of any size often overlook or underestimate this category of risk. It can topple your firm standalone just like market or credit risk, and often works in concert with the other types of risk to ruin companies.

A prime example is the most recent credit crisis of 2007-2009. It is the failure of internal processes and people, internal controls and lack of professional judgment and ethics which caused the demise of many financial institutions during the financial crisis of 2007-the present.

Identification, measurement, monitoring and managing operational risk is paramount. This is tied to establishing strong and efficient operating processes. This includes having well-defined, logical and organized roles and responsibilities, segregation of duties, internal controls and management review mechanisms.

Reputational Risk

Reputation may be viewed as the most important intangible asset possessed by the business as it represents the extent to which the firm is meeting the expectations of its stakeholders. A "reputation risk" can materialize when negative publicity triggered by certain business events, whether accurate or not, compromises the entity's reputation capital and results in loss of value for the firm.

You may want to consider defining and actively monitoring the effects of operational incidents on reputation capital and the perception of your business. This includes relationships and processes with customers, suppliers, employees and the community.

Too much risk management? The answer: Enterprise Risk Management

As a small business owner, you may be wearing many hats and overwhelmed as everything is a priority. How do you drive your business and manage all of these areas of risk and the associated costs?

Consider adopting an enterprise risk management method instead of approaching risk management within categories or silos as described above. Enterprise risk management is a strategic, top-down and holistic approach to risk management which incorporates market, credit, operational and reputational risk. Enterprise risk management can help you to define and align your risk appetite with strategy, and with the way you operate your business.