3 Ways to Stay on Top of Financial Risk

Short of hero worship but more than reserved respect, many people place undue accolades on entrepreneurs as risk takers. What is more risky? Having 100 percent of your income as an employee tied to one company for which you work or having a business that has hundreds of customers and therefore, many sources of income? It took me a long time to get my arms around this, but in a society where job security is no longer a given, I believe starting and running a business actually holds lower risk for people if done correctly. This is something to think about for people considering whether or not to start a business. While the idea of entrepreneurs being wild risk takers is not a correct impression, there is certainly significant risk in running a business. The purpose of this article is to help entrepreneurs minimize one specific area of risk: financial risk. For those already running a business, I’m going to address three ways to stay on top of your business’ financial performance in order to keep it safe:

  1. Don’t rely exclusively on rules of thumb. Because I’ve been in finance most of my life, years ago, I thought I would always have an intuitive grasp of Sageworks‘ finances no matter how large we became. However, as the organization got bigger, the more formalized and detailed our accounting and financial practices became. While it is true that most experienced entrepreneurs can have a good pulse on their businesses up to a certain level, after that level the business’ finances usually start to become more complex, where the entrepreneur cannot rely on reliable rules of thumb that worked in the past. At a minimum, make sure you have a process that’s not just in your head for regularly analyzing your financial performance.
  2. Have a good financial forecast and update it monthly. The basic building block of managing financial risk is a good financial forecast that projects, at a minimum, the following things: sales, expenses, profits and cash. Any business that has more than $1 million to $2 million in revenue should have a good monthly forecast for, at least, the next 12 months. Once you get to $10 million, you need a more detailed model-nobody could know the economics of their business without a model once the business gets to $10 million. You start to feel like you have vertigo when you reach $10 million; you’re trying to keep up with the numbers in your head, but you think you’re doing something when in reality you’re way off. These forecasts should be updated each month as conditions in the business change.To understand why a forecast is important, consider the concept of the “operating range” of a business. This refers to the financial phenomenon that fixed costs (costs that don’t change proportionally with revenue) tend not to grow consistently at a certain rate. Rather, fixed costs tend to jump in large increments within an operating range of time. Businesses can be very profitable, for example, in certain industries between $1 million and $5 million in sales, but at $5 million, they are required to make large financial expenditures that are fixed in nature. Therefore, when a business initially hits a new operating range of expense, the business needs to quickly grow their revenues beyond that level of expense in order to even match previous levels of profitability. The point is that revenues and expenses behave differently as a company gets larger, and good forecasting can help you see what your business looks like as it grows.
  3. Stress test the business. Another point to managing a forecast is to stress test the business. What would happen to the business if sales dropped by 20 percent in the next 12 months due to a recession or lost customer? How is cash affected as sales and profits grow? Because, as we know, higher profitability does not always mean higher cash balances, which is almost a clich. What you want to do is attack the business in the forecast (which is usually done in Excel) from as many angles as possible, changing different assumptions and variables to see how the business is affected. This will lead to better investment and hiring decisions because you have an array of possible outcomes as compared to simply looking at how the business is doing today.

Having a forecast and a model are the beginning points to give you a broad dataset of risk scenarios. It’s up to you to use that information to make the really tough, instinctual decisions related to financial risk management. You start with the model, stress test it, and that gives you insight into the changes you may need to make in your business to maintain or grow revenue, profits and cash. Don’t worry. Good entrepreneurs, with the aid of a model, often have either an innate or learned skill at hedging financial risk. It’s kind of a sixth sense born from the rigid discipline of building and following the financial model.