Predicting and analyzing risk is a difficult endeavor, especially since it involves anticipating unforeseen and adverse events. Of course, these events are hard to anticipate and even harder to plan for. But, risk analysis is essential to the success of any business.
Although it is highly unlikely that you will be able to anticipate risk factors with 100% efficacy, the process of thinking through potential risk factors and mapping out a plan for handling potential scenarios is a huge step in the right direction.
In this article, we will discuss
- what exactly risk analysis is
- why it is so important
- when business owners should consider undergoing a risk analysis process
- different methods of risk analysis
What Is Risk Analysis?
Let’s start with a definition, albeit a fairly complex one. Risk analysis refers to the process of examining the likelihood that a given risk factor will occur. This adverse event could be anything, from a pandemic to a sudden drop in cash flow to stock market fluctuations. In addition, risk analysis almost always includes a recommendation for how to control for and minimize the potential impact of these events.
Essentially, the risk analysis process helps companies calculate the value and risk factors of undergoing various projects. It is a tool for making sound business decisions.
To be successful, businesses always have to take on some degree of risk; the question is, when is it a worthwhile degree of risk to take and when is it not? This is what risk analysis seeks to determine.
Why Undergo A Risk Analysis?
Risk analysis is an extremely important process to undergo because — as stated above — it is virtually impossible for a business to grow without taking on a reasonable degree of risk. The tricky part is determining a reasonable degree of risk for a specific business at a given point in time.
You will never be able to fully foresee the possibility of certain events occurring (as we learned in 2020), but you can make reasonable predictions. When you combine these reasonable predictions with an analysis of how much your company can afford to lose and how much you stand to gain, you have a powerful method of assessing risk-reward ratios.
When Is The Best Time?
There are also more specific scenarios during which risk analysis can be extremely useful.
Risk analysis can be a useful tool in terms of project management. Conducting an analysis and assessment will help a business anticipate project risk, project success, and potential issues that might occur throughout the project. It will even help you to decide if the project is worth undertaking in the first place.
Risk analysis is also a useful tool to evaluate the risks of foreseen adverse events. If you know that a competitor is entering the market, or legislation is being passed that might negatively affect your business, conducting a risk analysis before then will help you to understand the risk factor’s potential impact. You can then develop strategies to mitigate risks before a project even begins.
Conducting a risk analysis is also advisable even when nothing out of the ordinary is occurring. Even during the best of times, there’s always a chance that something will go awry.
Stay on top of your risk management strategy and have evaluations ready for when equipment gets stolen, employees leave the business out of the blue, or natural disasters hit. This will save you a considerable amount of time and money, bringing peace of mind in the long run.
Different Risk Analysis Methods
So far we have covered
- what risk analysis is
- why it is important
- when it is particularly useful to businesses
Now, let’s delve into different risk analysis methods.
There are two overarching types of risk analyses: qualitative risk analysis and quantitative risk analysis. We will discuss broad themes of each of these types of analysis and then go into more detail by looking into specific techniques under both methods.
Qualitative Risk Analysis
Qualitative risk analysis is a good place to start. As the term implies, risks are not defined using corresponding figures or given numerical rankings. The qualitative method relies instead on written definitions and explanations of risk factors, their potential effects, and ways to mitigate them.
As you might imagine, there are many ways to go about conducting a qualitative risk assessment. This is part of what makes them so appealing. They tend to be very adaptable, and their scope can vary based on the project or scenario prompting you to conduct the analysis in the first place.
Another reason why qualitative risk assessments are a good choice is that they get various team members involved in the process. This method can be a great platform for collaboration to build upon.
Decision Tree Method
One of the most popular methods of qualitative risk analysis is the Decision Tree Method. This method is typically called upon when there is a question or uncertainty over the result of an upcoming project, plan, or event. The decision tree analysis process starts with the occurrence in question and maps out the different possible outcomes of that scenario, along with the avenues that it would take to get to those outcomes. It’s a visual mapping out of all the possible effects of one triggering event.
After all of the possible outcomes— and the roadmaps to them— have been established, the appraiser calculates the probability of each outcome occurring. At this point, you should have enough information about outcomes, pathways to outcomes, and the probability of outcomes to make a fully informed decision about how to proceed.
Quantitative Risk Analysis
Quantitative risk analysis is a little different. As most quantitative things are, this risk analysis method is built around numbers. Quantitative assessments utilize simulations to assign numerical values to various risk factors.
Unlike qualitative risk analysis, quantitative risk analysis does not rely on human subjectivity. Instead, inputs including the numerical values of risk factors, deterministic statistics, and random variables are entered into a risk model. That model then generates a range of outcomes.
Of course, the numerical values assigned to risk factors are still somewhat subjective, and the outcomes generated by the model are still somewhat random. But in theory, the randomness and subjectivity are constants across the different risk factors assessed.
The results of quantitative risk assessments are graphs, sensitivity analyses, and other metrics that provide a picture of the possibilities and impacts of various risk events. These enable the analyst to better develop plans to mitigate those events.
The Monte Carlo Simulation
A common method of quantitative risk analysis is the Monte Carlo Simulation. The Monte Carlo Simulation is a tool that generates a range of potential outcomes for different inputs of variables and numbers. This particular simulation tool is desirable because it generates a large number of outcomes. It repeatedly calculates results for the random variables inputted using a different set of values each time.
In the end, it provides a probability distribution graph of all possible outcomes, including the mean and median, standard deviation, and more. This can be a very effective tool if you are in need of a highly objective, statistical examination of the risk factors posed by a given scenario.
We Can Help with Risk Analysis for Your Business
We know it’s hard work to own a business and we’re here to help. Our team of business financial advisory experts is ready to create a plan that best suits your needs.
At Saddock Advisory, we can help determine if your business is financially healthy. Get in touch with us here to find out more.