Definition of Risk
As was noted in the post “What Value Really Means”, if you ask 5 people for their definition of risk, you will likely get 5 different answers. For me, a career Risk Manager of close to 15 years, I define risk follows:
“Risk measures an event which causes an outcome different from my expectation. With every event, there is a consequence and a likelihood of it occurring.” ~Bruce Everitt
That may look like a bit of a mouth full, and you may be thinking its time to stop reading because it hurts my head. Just wait. The following examples should make this definition sound more clear.
Most people are familiar with the concept of risk. In fact, we learn this concept at an early age. Consider for a moment the 8-year-old boy, standing in the middle of the kitchen taking in the glorious site and smell of freshly baked chocolate chip cookies. These are his mother’s specialty. His mother has told him that if she catches him taking a cookie (the event), he will lose his TV privileges that night (the consequence).
The boy stands there and thinks. The cookies are cooling on a rack, sitting within reach on the counter top. His mother has wandered off to the other end of the house (the likelihood). The event is that he gets caught. The consequence is loosing a night of TV. And mom is nowhere to be seen. When the boy measures all this up, the risk is low, and in a blink of an eye, he has made his decision and is quickly heading out of the back door to the privacy of his tree fort, with a warm cookie in his hands. He understands the concept of risk.
Consequences can be anything from monetary gain or loss, to physical gain or loss, to emotional gain or loss. The reason I say gain or loss is because “risk measures an event which causes an outcome different from my expectation.” It is the phrase “different from my expectation” that suggest the outcome could be positive or negative to me. It is just different.
It might make more sense with this example. I expect my sales this year to be $1 million. I have planned all my operations based on this expectation. What is the risk that my sales are different? If the sales are lower, then I have planned for a million with all the overhead and material. My profit will be lower, I may have to layoff some workforce, etc. If my sales are higher, I should be happy, and I am, however, it means I may not have enough capacity to meet the demand. My service or quality might not meet mine or my customer expectations. There is a down side to selling more than planned.
Likelihood really means probability or chance that it will happen. It can be measured as a percent. There is a 30% chance my sales will be below $1 million and a 10% chance they will be above $1 million. Likelihood can simply be a High, Mid or Low range. The chance of my sales being below $1 million is in the Mid range while the chance of my sales being above $1 million is Low.
Your View on Risk
With business valuation, it is important to understand the risks you face. Step 2 of “How to Increase Your Business Value” has to do with setting your own definition of risk. What is the best way for you to look at risk in your business? How do you want to measure it? How specific do you want your events to be? How detailed do you want your consequences to be? What method of assessing the likelihood will you use?