8. Analysis and evaluation of risk
(László Szőllősi)
When making a business plan we have to consider the occurrence probability of events. If the probabilities are unknown we must speak of decision making in addition with uncertainty, otherwise we speak of decision making in addition with risk factors.
A business plan is impressive if it addresses all risk factors entitled which can or are in effect of an enterprise or project. We differentiate risks according to their weight, or impact and not every of them enable us to be prepared. For the sake of the latter, we express alternatives while planning to show investors that we are prepared.
When implementing a “What-If” analysis, or a risk assessment we try estimate impacts on performance indicators (such as: earnings, cash flow, equity etc.) rising through differences of effects as we are using best-estimates method, or probability indictors. First identify impacts and indicators of performance, then their probabilities. From these we can determine expected values.
The goal of the “What-If” analysis is to select the critical variables and parameters that cause the greatest modification factor and impact. The sensitivity analysis can be carried out in many ways such as elasticity examination, critical values method, or as a scenario analysis.
Elasticity, flexibility of variables are also examinable. These reflect of what happens if production factors are in one percent change, and how many percent changes in reaction with this (ceteris paribus). The result expresses the sensitivity in reflect of the indicator. If the result is higher than 5% it’s considered critical according to EU standards.
Another option to complete a sensitivity analysis is to make a critical value calculation. This reflects the input need of financial and technological values to a minimal expected result.
Ceteris paribus is effect also. Here we note that the break-even point analysis is a kind of critical value test.
As a third option we can find have a scenario analysis. Here most critical points are identified, and examined by an analysis. The scenarios analysis makes two outputs (usually a negative and a positive, or simply an A & B) in addition to the base-case. From these we can make a comparative analysis.
The sensitivity analysis enables us to study the effects of one or a few (limited) variable value changes. In contrast, the probability of a Monte Carlo simulation analysis method enables examination of all the possible combinations. That allows us to study the distribution of the entire business plan outcomes. After appropriate modeling of the studied business we will be able to run computer simulations with random values. This method is very beneficial to quantify and study the risks using a sufficient sample size.
Risk factors can be described differently. In the following one possible way will be introduced.
Production Risk: Yield loss, quality change, production losses may manifest, which may be due to weather, disease, pests, equipment failure, etc...
Market risk: Market risk is primarily in relation with products, services or the purchase of raw materials, fluctuations in prices of services produced. We have to mention difficulties of selling produced goods and services.
Financial risk: The risk of financial activities in order to finance the assets of the business. Here we can highlight the changes in the loan interest rate, foreign exchange loss in case of exports, the loss of land lease rights, etc.
Random risks: Catastrophes may be considered here.
Legal risk: Governmental factors of outside environment which are through political facilitators.
Human risk factors: are often neglected, but the success of the enterprise can significantly affected by the managers’ suitability, reliability, health and family relationships. In case of loans banks use these circumstances especially for small businesses.
In addition we must distinguish between factors dependent and independent from an enterprise, because their control will be different. Dependent risk factors should be controlled preventively. An enterprise should use all its resources to take evasive maneuvers in order to evade negative effects. Examples include losses due to equipment failure, which risk can be reduced by regular fleet maintenance and continuous renewal or replacement. This is a decision to make by the entrepreneur. On the other hand, independent risk factors are irresistible, their impact can only be minimized. A good example is weather. An enterprise has no effect on occurrence, but it might suffer from its impact. Casualties may be lowered by insurance.
The itemized list of risk factors must be collected and analyzed in detail and where it’s possible quantified. The theoretical formula for risk estimate is occurrence probability multiplied by impact in performance indicators. Risks can be positioned through generous quantification and numeration, based on occurrence opportunity and impact (Figure 8.1)
Figure 8.1. Positioning risk based on impact and probability Based on: NFÜ, 2008
Based on the risk analysis we must formulate solutions the deal with probable impacts. Here are some methods to treat risks:
Cancellation of project (parts).
Setting up reserves
Offloading risks by insurance mechanisms
Risk sharing
Control questions:
1. What is uncertainty and risk?
2. What are elasticity indicators?
3. What is a critical values analysis?
4. What is scenario analysis?
5. What are the essentials of a Monte Carlo analysis?
6. How can we group risks? Describe them shortly!
Competence development:
1. What kind of risk analysis methods you know? Describe them shortly!
2. When and where are these used?
3. How can we control dependent and independent risk factors of an enterprise? What’s the main difference between them?