Risk-taking is a part of business. Being able to realistically evaluate what each risk means, then, is a valuable skill for any entrepreneurs. While instinct does play a part in some types of risk evaluation, the only reliable way to judge whether a risk is worth taking is to undertake a formal risk evaluation.
Formal risk evaluation compares the likelihood of a risk against the severity of consequences. Risks that rate high on the list are more of a gamble, and therefore usually to be avoided.
Creating a scale of likelihood
The easiest way to judge the likelihood of a risk becoming reality is to analyse your industry. A retailer, for example, might wish to analyse the risk of a certain product not selling. By studying other sellers, the retailer can judge how frequently this occurs, and rate the risk.
Likelihood can generally be rated out of four: the highest score for most frequent (more than once in a period of time such as a year or a month) and the lowest for least (has only ever happened once in that period).
Measuring against consequences
The most useful scale for consequences in business is financial loss. The loss of tens of thousands of dollars is a serious consequence for any business. The loss of a few hundred, however, can generally be coped with. Rate the most serious consequence the highest (four).
Rating systems should be altered to fit your business and the situation. Some situations call for more fine-tuned assessment, so four ratings won’t be enough. Consequences don’t always come in dollar form, either, so things like health or losing staff can be substituted.
Using the calculation
The two ratings should be multiplied against each other to create a risk rating. The risk rating scale should then be set out from highest to lowest. In our example so far:
High likelihoods x high consequences = 12-16 – a severe risk that requires immediate action
Second highest = 8-12 – a high risk
Third highest = 4-8 – a moderate risk
Lowest = a low risk that could be prudently ignored.
With our retailer, for example, if the product goes through two periods of low sales per year (a likelihood factor of two), but the loss is a large one (high end products costing thousands of dollars, rating three), then the risk has a rating of six. Whether this moderate risk is worth taking will depend on the retailer’s circumstances, and on the reward if the gamble pays off.
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Risks don’t always involve business ventures. Risk evaluations should be undertaken for major business issues and dangers to the business, from lapsed insurance policies to fire dangers. In some instances, a high risk factor can be obviated by some business assistance.