Risk is defined as, “the possibility of loss or injury” according to Merriam Webster Dictionary.
In the context of business valuation, that usually means the possibility of reduced cash flow, which corresponds to a loss in value. The higher the probability that cash flow could be affected, the greater the risk to the business.
The easiest way to remember the relationship between risk and value is:
As risk increases value decreases
Risk can generally be categorized as coming from things internal to the business or external to the business. Starting with external risks, the biggest external risk for most companies is competition. However, external risk can come from many other areas including:
- Regulatory changes;
- Technological advances;
- Catastrophic events such as a bombing in Boston or Hurricane Sandy in the Northeast; and
- Economic changes
While the occurrence of external risk factors may be impossible for a business to control, many businesses can take steps to minimize the impact of external factors. A company that anticipates a regulatory change can often modify operations to work around the change. Sometimes, companies can even find ways to benefit from change by offering improved products and services. For example, hospitals have been anticipating the mandatory use of electronic medical records (EMR) for years. Those who have embraced and implemented EMR may be in a superior position to compete with those who got a late start in implementing EMR.
Another way companies can often protect themselves, is by using insurance policies to cover the economic impact of catastrophic events. Though insurance may not provide 100% coverage for a loss, it may provide sufficient coverage to minimize the impact to the value of a company. Insufficient coverage may be a risk factor that a company has not considered.
There are also internal risks to a company, which arise from the reliance on internal resources. Internal risks arise when there is dependence upon key personal without contingency or succession plans. They can also arise when a company has a poor accounting system and limited internal controls. Any operational weakness gives rise to an internal risk.
Internal risks may be easier, in theory, to control. However, in practice, it is often harder for owners and managers of a company to recognize and mediate internal risks. For example, an owner may not see the value, in terms of cash flow, to implement a new accounting system to have better reporting. The short-sighted view is that these investments in a new system will not increase revenue or cash flow. While this may, on first blush be true, good financial reporting increases a manager’s ability to monitor revenue trends as well as manage the expenses of a business. When this can be done in real time, rather than strictly on a quarterly or annual basis, management has the ability to change operations to benefit for trends or save money when spending is not necessary. Internal control systems, such as POS (point of sale) systems, may not appear to generate revenue until an owner realizes that employees have been skimming cash from the registers for years.
So back to value: the lower the risk the higher the value.
A company can increase its value by reducing its exposure to internal or external risks associated with operations. Future posts on the blog will focus on ways businesses can minimize risk, thus increasing value.
If you have questions about this or other valuation matters, please contact me.
©2013 Florida Business Valuation Group
