January 3, 2019 Last updated January 2nd, 2019 537 Reads share

How Can You Quantify Business Risk?

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Entrepreneurs are often well acquainted with risk. They know that starting a business is inherently risky (as about half of businesses fail within the first five years of operation) and they’re often willing to stake tens of thousands of dollars (or more) and months to years of their lives in that pursuit.

That said, the concept of ‘risk’ doesn’t have to be scary. It’s unwise to consider risk as an inherently bad thing since all risks involve a chance of success as well as a chance of failure. The best entrepreneurs are the ones able to calculate the relative severity of the risks they face, and take the ones with the best chances of paying off in their favor.

In other words, being a risk-taker isn’t going to instantly make you a better entrepreneur. Instead, the best entrepreneurs are the ones able to most precisely calculate risk—but unfortunately, risk calculations aren’t always as straightforward or reliable as we’d like them to be.

Are risks quantifiable?

Some risks are quantifiable. In fact, the entire insurance industry revolves around quantifying risks with underwriters and data analysis. You might be able to calculate, for example, the average monthly revenue for businesses like yours in your city to determine how viable your business model is.

Other risks are much harder to quantify because it’s impossible to know all the variables involved. For example, it’s hard to know whether your new product will make you stand out from the competition, or fall flat with your existing customers (even with preliminary information from early customer tests).

Ultimately, the quantifiability of a risk depends on how many known and unknown variables there are. For example, you may know that 8 of your 10 test subjects liked your new product, but you don’t know how the rest of your 100,000-strong potential audience will react, and you don’t know how market conditions will change in the near future.

There are four types of business risks to consider:

1. Strategic risks involve market conditions and the high-level vision for your business. These tend to involve both objective and subjective factors, making them relatively difficult to predict. For example, you may be able to run an analysis on your current competition, but you can’t gather information on up-and-coming competitors until it’s too late.

2. Compliance risks involve your ability to meet new health and safety laws. These are fairly predictable, and with the proper precautions, you can mitigate your risks here—but there’s always a chance of a rogue or noncompliant employee compromising your efforts.

3. Financial risks include customers not paying or unexpected increases in your business loans. Credit scores and airtight contracts can help you calculate and/or avoid some risks here, but there will always be some unknown factors.

4. Operational risks are related to the breakdown and/or reliability of your key equipment and personnel. There are both easily calculable and largely unknown variables at play here.

As you can see, different types of business risks bear different levels of calculability, but no risks are purely quantifiable, there are always unknown variables that could interfere with your calculations.

Accounting for all risks

One of the most important steps to take, therefore, is finding a way to mitigate risk, or protect yourself against it, no matter how it arises. Getting comprehensive business insurance, for example, could feasibly protect you against strategic, compliance, financial, and operational risks all at once (depending on your specific policies). That way, even if your calculations are off, or even if there are risks that you just can’t quantify, you’ll have some level of protection to keep your business healthy and thriving.

Tips for quantifying the risks you can

Business insurance shouldn’t give you carte blanche to take risks on a whim; instead, you should consider it a last-ditch safety net in case your primary strategies go wrong. That means you need to invest more time, resources, and strategic thought into quantifying the risks you can, with these tactics:

  • Know the formulas. There are several common formulas you can use to estimate your risk in various areas. For example, your contribution margin ratio can be calculated with contribution margin over sales = 1 – variable costs over sales. If your contribution margin is 10 percent, for example, then a $100,000 increase in sales will result in increased profits of $10,000. These ratios can’t help you determine risk in all areas but can help you calculate hard, numerical values for factors that may otherwise go unquantified.
  • Look at historical data. Next, gather historical data whenever you can. You might have to do a little digging, but chances are, you can find similar situations in the past. For example, you might look at how often natural disasters strike in your area to determine the threat of a natural disaster to your business, or you might look at performance statistics from businesses like yours to estimate how your revenue will grow over time.
  • Attempt to quantify severity. When calculating risk, don’t mount it to a simple “pass or fail.” For example, you might face risk with a 60 percent chance of success and a 40 percent chance of failure; if that “failure” is minimal, it may be overwhelmingly worth taking the risk, but if that failure is catastrophic, you may want to keep your distance.
  • Get multiple opinions on subjective calculations. Sometimes, you’ll be forced to quantify something that’s not easily calculable with objective metrics. When you’re in this position, see if you can get multiple knowledgeable people to estimate that risk. Averaging three independent estimates will get you closer to the truth (and filter out cognitive biases that may otherwise affect your total).

Not all risks are inherently calculable, but almost all of them have at least some calculable components—which you can use to your advantage. The better you are at quantifying the risks your business faces, and the better protected you are against unknowable and unpredictable risks, the higher your chances of success will be.

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Anna Johansson

Anna Johansson

Anna is a freelance writer, researcher, and business consultant. A columnist for Entrepreneur.com, HuffingtonPost.com and more, Anna specializes in entrepreneurship, technology, and social media trends. Follow her on Twitter and LinkedIn.

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