Risk management

Manage uncertainty in business with risk management

Growing companies face uncertainty in all parts of their business. Uncertainties around product quality, customer loyalty, operational capacity, financial structuring, tax and access to capital have always been a fact of life for smaller, high-growth companies.

As companies grow, increased complexity and urgency makes it harder to foresee the ramifications of decisions. This may be appropriate whilst the company is relatively small, but as the business grows it becomes more efficient to put in place strategies, policies, processes and systems to support decision making.

Risk management - the identification, assessment and management of risk exposures - can enable clever companies to consistently and systematically manage the uncertainties inherent in a growing business with transparency and accountability.

Risk management is of benefit to any company in which the proprietor wants to devolve responsibility and accountability for decisions to a wider group of managers and employees, developing sustainable decision making capabilities in the organisation.

While risk management systems will add some formality, they shouldn’t reduce flexibility. As the proprietor normally makes the major decisions in most private companies, their risk management systems can and should be less rigid than those used by larger companies. The proprietors of smaller businesses have a fine tradition of making successful decisions based on gut feelings. The principles of a more formal approach to business should be centred on providing guidance on what risks to take and how much risk the business can withstand when making decisions.

Evaluating options

Developing a full range of real-time systems to identify and monitor risk is prohibitively expensive for most private businesses. As a result, it’s best to look at risk as a number of options available to the proprietor or management team. A risk management strategy clarifies who is responsible for making decisions and the basis upon which they make them.

Designing a risk management system involves answering following questions:

• What is the company’s long-term direction? How does it intend to operate and make money into the future?
• What creates value for the company and what are the potential threats, uncertainties and opportunities that impact those value drivers?
• What management processes need to be put in place to plan, deliver, execute and monitor the company’s strategy and the risks associated with it?

A long-term vision

Risk management starts with clear goals. Once a company decides to make executives responsible for important decisions, more clarity around goal setting is required to ensure everyone is working towards a common aim. Goals should be measurable and objective, such as dollar sales targets or increases in profitability.

These objectives are not always very transparent in a private company. For example, some proprietors will not wish executives to know how much money the business makes.

The first stage of developing a risk management strategy is having a clear understanding of what activities the company intends to undertake in order to create business value. The company’s broader system of values and objectives will set the parameters under which it performs these activities.

What produces value?

The next stage involves finding the activities that have the highest impact on the value of the business and prioritising those that are the most uncertain or volatile. This may require some analysis, including identifying the activities or ‘value drivers’ and determining their sensitivity or volatility.

For example, property development companies that bring in outside equity or debt to fund projects will find that cost of capital has a huge impact on their investment’s value. As such, risk management should focus on optimising the cost of capital. For companies that have fixed costs, such as software companies and wholesalers, turnover growth is likely to have the greatest impact.

Risk management should not focus on historical variance analysis – the difference between budgeted and actual figures. Rather it’s about looking forward and understanding what risk factors will prevent a company from meeting its budgeted figures and then managing or mitigating those factors.

Plans and metrics

Once the main activities have been identified, establish the acceptable operating ranges and put in place appropriate mechanisms to monitor them, and possible responses if anything goes wrong.

For example, if a large proportion of a company’s business comes from its top 10 clients and five of those clients’ contracts come up for renewal at once, the company should consider plans to deal with the potential loss of some or all of those customers.

Another example is seasonal sales in retailing. Many retailers expect a drop in sales at certain times of the year, so these businesses should have options to reduce costs if demand falls, including analysing the optimum temporary versus permanent employees roster mix to respond to this seasonality.

Monitor risk factors using leading as well as lagging indicators. Relying on lagging indicators such as budget to actual variance will not identify a significant risk until it’s too late. For example, cash collection is one the most important value drivers for professional services firms. A commonly used indicator for the health of cash collection is the average number of days outstanding in accounts receivable. However, because days outstanding is a lagging indicator, by the time its reaches a point where it is considered a problem, the company may already be in trouble.

A leading indicator would provide advance warning that people aren’t going to pay their bills. Customer satisfaction levels might suffice. When customers don’t pay their invoices on time it’s often because they are unhappy with service. A sudden drop in customer service levels could be an early warning of late payment giving the company time to implement corrective measures.

Risk management is not the answer to all ailments. But it can provide a powerful mechanism to understand uncertainty and volatility in the business and develop the right strategies to economically manage any such exposures.

• This information is provided by Price Waterhouse Coopers
  
  Risk management for private companies