Risk analysis

Risk analysis or risk management are concepts usually associated with financial institutions or large corporations. But risk is something that also small businesses encounter on a regular basis. They may however shy away from performing risk analysis since this concept may seem so “big enterprise”. But it’s not. Risk analysis is simply the identification and evaluation of scenarios that may happen.

Let’s define first what risk is. With risk we usually mean the chance that something undesirable will occur, which we then try to avoid or minimize. But risk can also mean a chance that something desirable will happen. In either case, the more uncertainty exists about the potential outcome the riskier we perceive it. Hence, to reduce this uncertainty and risk we should increase our knowledge about the uncertain events.

What are the sources of uncertainty? In business situations uncertainty arises in many ways. Demand for company’s products for example is uncertain since it depends on many economic factors and sometimes unknown customer preferences. Optimal prices to charge for company’s products or services may be uncertain since they are driven by unknown customer expectations and competitors’ pricing. And even operating expenses may be uncertain when it comes to forecasting required investments needed to bring a product to market.

Some of these uncertainties are outside of company’s control. Weather, for example, is an uncertainty that cannot be controlled and if you are selling umbrellas this uncertainty will impact your sales. But you can at least prepare yourself by analyzing potential weather scenarios and ordering the number of umbrellas that will maximize your profit. Other uncertainties, on the other hand, can be reduced by company’s actions. For example the uncertainty about optimal product pricing can be reduced through market research and pricing analysis helping to narrow down on only few desirable price points.

Most businesses need to make decisions in light of these uncertainties by taking calculated risk. Risk analysis provides the means to make this calculation. Risk analysis is nothing more than the analysis of potential uncertainties that may have an impact on the business. This scenario analysis can help to quantify the potential risks.

Scenario analysis in its basic form identifies few potential cases of what could happen. In this basic form, however, usually only few scenarios can be evaluated although in reality there are many uncertainties that need to be analyzed at once. Here is where Monte Carlo simulation can help.

Monte Carlo simulation is a sophisticated scenario analysis that can evaluate thousands of scenarios at once. Businesses can then better understand the uncertainties they encounter. You can find more about Monte Carlo simulation either in one of our previous posts or in our Monte Carlo simulation tutorial. Needless to say, Monte Carlo simulation is embedded in some of FinanceIsland’s tools to help identify for example potential outcomes of return on investment or company’s cash flows. This allows every company to perform risk analysis.

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