All businesses take some amount of risk. Just opening the doors for the first time involves the risk of capital and labor. From then on, every business decision could be thought of as a risk reward trade-off. For most decisions, we probably don’t take the time to think of them in that light. We go about our day to day activities and accept the risks in our business. But there are certain decisions where one should definitely be thinking about risk and how it affects the overall business.
I believe many businesses become more risky over time. While most small businesses don’t specifically measure investment activities versus their risk adjusted cost of capital, larger businesses (certainly the Fortune 500) do so regularly. But even these businesses are not necessarily good at it. Too often, they tend to assume that all of the projects they undertake have the same risk profile.
For the moment, let’s assume that there are only three risk categories (high, medium and low) and that the business operates in the middle (medium). Let’s also assume that a fair return on those projects is 20% for high risk projects, 15% for medium, and 10% for low. The specific numbers in this case are not meant to suggest that they are the correct return ratios for any particular business, but merely for illustration.
Over time, a business will look at many investment opportunities. If they measure all of them against a medium (15%) investment threshold without considering individual project risk the result will be a shifting of risk over time. Low risk projects won’t meet the medium risk threshold and will get denied (even though one shouldn’t expect them to achieve as high a return because they are safer). The high risk projects will disproportionally exceed the return threshold because they aren’t being held to a high enough standard. More of these projects will get approved (and a higher than anticipated amount will fail). The ultimate result will likely be a business whose risk profile shifts over time.
Think about what has happened in the financial services markets lately. There is a strong argument to be made that there was a lack of understanding of the risk of the underlying investments. Simply put, historical mortgage default rates (and therefore risk) of people who used “traditional” mortgages with 20% down payments is lower than that of highly leveraged “nothing down” borrowers. Using assumptions based upon the former group to underpin investments in the latter group resulted in a mismatch of the risk-return paradigm.
So, how does a small business deal with assessing risk? To start, I would suggest thinking about the risk profile of individual project decisions and ask some questions. Are the assumptions conservative or aggressive? Have we completed a similar project before? What is our confidence that we can achieve the result? Can we accurately measure the results? How have others fared in similar circumstances?
If you conclude that a project is high risk, make sure that you are getting adequately compensated for that risk. On the other hand, if the investment opportunity is low risk, it should not be ignored just because it doesn’t meet a preset threshold that doesn’t consider that fact.
If your business could benefit from fractional CFO services, I would welcome the chance to speak with you. Please give me a call at (314) 863-6637 or send an email to
your cash is flowing. know where.®
Ken Homza
Copyright @ 2009 Homza Consulting, Inc.