Financial risk analysis is key for every small business owner, as it helps identify existing or potential risks before they have a major impact on the business’s bottom line. In this article, we will discuss what a financial risk analysis is and why every small business owner needs one.
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What is financial risk?
Financial risk arises when you make a decision related to finances without properly examining the consequences. It could be due to neglecting factors such as payback, long-term costs, or monthly payments.
In business, there are different types of financial risk. For example, if your business is highly cyclical, taking on a large number of payments may not be advisable. You may not know when you will have more cash flow than other times, requiring you to maintain more cash. Another type of financial risk is acquiring a new company when your internal processes are not under control. Incorporating such an acquisition into your business can be a major financial risk.
Executing a Risk Analysis
What Is Risk Analysis?
Simply put, a risk analysis (or financial risk assessment) is essentially assessing the impact a decision will have on an organization’s financial health.
What is the purpose of financial risk analysis?
A risk analysis is critical to making effective, strategic decisions for your organization. No matter what size you are, no matter how many clients you have, and no matter how your business is structured, it’s always a good idea to go through some exercise (whether it’s a payback calculation or an internal rate of return calculation) to understand what you will be financially obligated to and when you can expect a financial return on an investment or purchase before it’s made.
For example, a business might be looking at buying a piece of equipment. Determining the financial risk that poses to your organization means understanding things like when you have to have the equipment purchase paid off. What’s the profit margin on the use of the equipment? What financial risk does that pose to your organization in terms? How much profit margin you can make on that machine?
Another scenario might be that a business is looking to acquire another organization. In that case, the assessment process would include answering questions like, “Will this acquisition add a lot of value to my organization? Will the additional costs outweigh the profit to be gained from the acquisition? Or will it simply be too costly for my organization?”
Additionally, there should be a minimum of a three-year projection of the balance sheet, profit and loss statement, and statement of cash flow in place when evaluating an acquisition. You want a realistic idea of what your cash flow will look like over those three years (assuming you spend on the acquisition). You want to know if and when you are going to make your money back.
Ideally, a purchase or acquisition (whether it’s of a business, equipment, tools, etc.) should be able to cash flow itself (meaning it can cover its own debt payment). That would make it a very safe, low-risk purchase.
What are the main components of a risk analysis?
The components of risk analysis are straightforward. Start with an understanding of cost, whether from a quote on the piece of equipment, you’re considering or a prospectus on the organization you might purchase. Start with the purchase price.
Then, you’ll know whether you’re going to have to take a loan against it. If so, gather the terms of the loan including the interest rate and the total cost of a monthly payment. That’s where you start.
How do you write a financial risk analysis?
Once you have the basic info associated with the purchase, you really want to consult with a qualified professional. Though gathering the basic info needed to start an analysis may be simple, executing the work is not.
This professional, whether a financial consultant or CPA, will work with you to gather any remaining information they need to make the calculations necessary for the analysis.
These might include calculating discounted cash flows, the cost to capital, internal rate of returns, payback, and other types of analyses that most business owners (and most professionals outside of finance) really aren’t familiar with and that are labor-intensive to complete.
What are financial risk factors?
Just as there are different types of risks, there are different types of risk factors: internal and external. Some internal factors worth considering include:
- your current state of cash flow
- realistic and achievable long-term sales goals
- whether or not you have retained work and/or clients
If you have some of those things in place, you should have good data from which you and your financial professional can begin to determine your risk profile (i.e. how much risk your organization can take on) based on your ability to pay for it. This will help you understand your risk appetite, too.
External factors worth considering include:
- your corporate credit rating
- the favorability of your Dun & Bradstreet profile
These are things that will impact whether or not you will qualify for a loan (if needed) and what terms might be offered to you on that loan.
Why is risk analysis important?
Executing a risk analysis is like buying insurance. People buy insurance policies for the unforeseen. They buy them to hedge their bets or as protection against things that might happen in the future. Risk analysis is a very similar thing. You’re taking a deep dive into your operations here and now as well as what your future may look like (including problems and challenges that might arise). Some of these challenges might be short-lived whereas others aren’t. By identifying the ones that aren’t, you can start to plan for how to deal with them.
Using Financial Risk Analysis in Decision-making
A financial risk assessment should always be the first step before moving forward into any sort of financial acquisition scenario. An effective assessment forces you to take a hard, thorough look at your financial position (which can only ever benefit your operations).
Then, the completed analysis will ensure you fully understand the financial obligations of a purchase, allowing you to be confident in your decision to make that purchase now, later, or not at all.
Why Work With Margin Authority
At Margin Authority, we focus on helping business owners manage their company’s financials for faster, more profitable, and more efficient business decisions. If you’re looking to make any strategic decisions or operational changes to your business, let us help. It’s what we do. Reach out to begin your financial risk assessment today.