Risk Management for Small Businesses: Identifying and Mitigating Financial Risks
Would-be entrepreneurs worried about the risks of starting a new business should remember the words of Meta CEO Mark Zuckerburg:
“The biggest risk is not taking any risk.”
Still, trying to build a company of your own does involve a lot of financial risks. So one of your many tasks as a small business owner is risk management — that’s both identifying and mitigating numerous potential pitfalls.
Today, we’ll help you with both.
Identifying Financial Risk
First things first: You have to know what kinds of financial risk you’re looking for. While there are hundreds of specific types of risk, they all fall under a handful of broader categories, including:
- Operational risk: This refers to any potential downsides from the actual day-to-day management and operation of the business. This ranges from a faulty business model to poor management to even fraud, among other operational risks.
- Liquidity risk: Liquidity refers to how much cash (or assets that can quickly be converted to cash) a company has. A very “illiquid” company doesn’t have much cash or convertible assets. And that could be an existential problem should an emergency arise that requires that company to quickly raise cash in order to survive.
- Credit risk: This doesn’t necessarily apply to every company. But in short, if you offer credit to customers and vendors, credit risk is the risk that you might not be paid back.
- Legal risk: In many cases, you might be legally liable for product defects or service failures. A very basic example is that a person could get injured while using one of your products.
- Market/macroeconomic risk: Of the five risks mentioned here, market risks are the least in your control. In short, market risks are changes to the broader environment you operate in. For instance, energy companies are greatly affected by changes in oil prices. Companies that issue a lot of debt can be negatively impacted by rising interest rates. And virtually all companies would suffer from an economic downturn.
Mitigating Financial Risks
It’s extremely rare that you can completely eliminate any type of risk, but in many cases, you can reduce either the risk or the potential damage of the risk.
While it’s not an extensive list, here are a few things you can do to mitigate various types of financial risks.
Stress-Test Modeling
Following the Great Financial Crisis, the Federal Reserve began conducting annual “stress tests” on the nation’s banks. These stress tests determine whether the banks have enough capital to survive a variety of adverse conditions. Small businesses should do the same. In short, you run a number of scenarios — say, a sudden 20% drop in revenue, or the collapse of one of your main assembly lines — to determine how your business would be impacted and whether your business would survive.
This not only helps you prepare for negative situations — it helps you determine what you need to do should your stress test results fall short.
Monitoring Your Cash Flow
In any business, big or small, cash flow is everything. That’s because cash is the very real money going in and out of your business. Your business could be projected to make a massive full-year profit, but if you mismanage your cash flow, your business could still go under. So always keep an eye on your cash flow. And ensure that you always have enough cash stowed away to cover expected expenses (and beyond).
Diversifying Your Customer Base
Whenever a company is preparing to go public, they have to file an S-1 with the Securities and Exchange Commission. Within that form is a section called “risk factors” where they have to list various noteworthy risks to their business. One such risk is called “concentration risk.” This is where a high percentage of revenues come from one product, line of business, or customer. For instance, a company that receives 75% of its revenue from a single customer has high concentration risk.
So as a general rule, you want to diversify your customer base. That means adding many more customers, often by expanding your product or service lineup.
Setting Up a Business Line of Credit
One of the keys to managing your small business finances is to secure access to credit (ideally on good terms) before you actually need it. Much like a credit card, you’re not charged for a business line of credit until you actually borrow money against it. And much like a credit card, it’s much more difficult to be approved (or at least, to be approved at a decent rate) once you run into a difficult financial situation and suddenly need that credit.
So once you’ve built up a good business credit score, inquire with your bank about a line of credit.
Asking the Experts
Especially if you’re a new small business owner, you might not be aware of various risks your small business faces. And that’s an easy way to trip into danger.
Our advice? Don’t get caught off guard just because you don’t have in-house expertise.
McManamon & Co. is a accounting, tax, fraud, forensic and consulting firm that offers custom services to small and midsize companies across a broad spectrum of industries. And we can provide expert advice on a wide range of issues — including identifying and mitigating the various risks your company will likely face going forward.
Reach out and get the info you need — call 440.892.8900 or contact us online.
Tags: financial literacy, McManamon, McManamon & Co., small business, small business finances | Posted in McManamon & Co., small business, Small business finances