Financial risk for entrepreneurs
I am on the topic of entrepreneurial risk. The following major risks for entrepreneurs were identified and discussed in the previous two articles: Product risk, Market risk, Financial risk, Team risk and Execution risk. The Financial risk component is a crucial element for entrepreneurs and I could not do it justice in just one delivery, so I want to continue with that conversation.
Financial and Business Risk
Although I am treating it under one heading, “Financial Risk”, I do want to differentiate between Financial- and Business Risk – since it both has to do with finances. Financial risk refers to the chance a business’s cash flows are not enough to pay creditors and fulfil other financial responsibilities. The level of financial risk, therefore, relates less to the business’s operations themselves and more to the amount of debt a business incurs to finance those operations. The more debt a business owes, the more likely it is to default on its financial obligations. Taking on higher levels of debt or financial liability therefore increases a business’s level of financial risk. Business risk refers to the chance a business’s cash flows are not enough to cover its operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk is independent of the amount of debt a business owes.
Let me address Business risk first. There are two types of Business risk: systematic risk and unsystematic risk. Systematic risk refers to the chance an entire market or economy will experience a downturn or even fail. Economic crashes, recessions, wars, interest rates and natural disasters are common sources of systematic risk. Any business operating in the market is exposed to this risk, and the amount of systematic risk does not vary between businesses in the same market. Therefore there is little business owners can do to decrease their exposure to systematic risk. The current economic situation and drought in Namibia is a perfect example of this type of risk. Unsystematic risk describes the chance a specific company or line of business will experience a downturn or even fail. Unlike systematic risk, unsystematic risk can vary greatly from business to business.
Sources of unsystematic risk include the strategic, management and investment decisions a business owner faces every day. In essence, this risk is mostly managed by the decisions the entrepreneur takes.
To give a very simple but effective example, when the business is struggling to make ends meet, it might not be the best time to buy that new 4×4…rather use the money to pay wages and operational cost to keep the business running.
In terms of Financial risk, specifically referring to the case where you finance your business with debt, there are a number of things to keep in mind. 1. Keep a lid on debt. If you have debt, manage it. Refinance variable rate debt with a fixed rate debt which ensures future payments to your lender are more predictable.
Alternatively, if possible, convert the debt into equity, giving investors a slice of the company in exchange for funds. 2. Insure against specific risks. It is important to know the specific risks the business faces and insure against them. A retail shop, for example, should insure inventory. 3. Focus on cash.
Many entrepreneurs shy away from the financial aspects of running a business, but if you should take away only one thing in all the articles I have written, it is this: Learn about cash flow and how it effects your business.
Cash flow is the blood that keeps the heart of the business pumping.
Cash flow is one of the most critical components of success for a business. Without cash, profits are meaningless. Many a profitable business on paper has ended up in bankruptcy because the amount of cash coming in doesn’t compare with the amount of cash going out.