To be honest, I’ve debated about whether I should write about financial modeling. If you’re anything like my girlfriend Amy, the mere thought of financial modeling causes great anxiety and a profound desire to change the topic. And I’m pretty sure that a post on creating spreadsheet representations of your business may not go viral.

.

But the simple truth is that financial models are incredibly powerful tools and they’re not that hard to create. Models are also required to do certain types of risk evaluation (as I talk about here, here and here..) In fact, models of the financial kind can be kind of sexy – at least to the engineering types like me.

.

Well, now that I think about it the models really aren’t that sexy…did I mention that financial models are incredibly powerful?

.

So what is a financial model?

.

It’s a numerical representation of your business. It shows revenues, expenses and cash flow and all of their components. A model lists all of the assumptions (and there are a lot of them) with the assumed value for each. If you use formulas when you create the model, it’s possible to test different scenarios by changing the assumed values.

.

Here’s a simple example. Fred owns a coffee shop. In his model, he calculates revenue by assuming the number of cups of coffee he will sell each month and multiplying that number by an average price per cup.

Sales = # of cups x $/cup

In this example there are two assumptions. That means there are two risks and two opportunities, right? The actual result for each assumption could turn out to be wrong in a negative way (a risk) or wrong in a positive way (an opportunity). By changing the assumed values, you can see the financial impact of risks and opportunities directly from the model.

.

You can apply the same technique to the direct expenses, the overhead expenses and even cash flow factors like how quickly you pay your invoices and how quickly you get paid by your customers. I arrange the numbers in a column for each month. The end result looks very similar to an income statement (a.k.a. P&L report).

.

I’ve done a lot of financial models in my time – for business planning, budgeting and forecasting. I continue to be amazed by the amount of information a good model will give you.

.

I’m going to continue this series and give you some more detail on financial modeling over the coming weeks. I’ve also created a public sample financial model for Fred’s Coffee Shop. You can check it out here (I’m using Google documents since they are easy to share. I typically do my modeling in MS Excel). Feel free to make a copy and play with it. So far I’ve only created the income statement portion of the model, but I’ll be adding some cash flow components to it.

.

Don’t hesitate to contact me with any questions. This type of modeling has become an area of expertise for me (in MS Excel spreadsheets) and I’m happy to help.

.

Do you use any sort of financial modeling in your business? I’d love to hear about your experiences.

Related articles by Zemanta

• A Financial Model is Not Black Magic (startupprofessionals.com)

In our last conversation about risk management how-to’s, we finished up the discussion on evaluating risks. If you are able to utilize some sort of financial model to estimate risk impacts during your evaluation, you now have a rather lengthy list of risks with their probable impacts. That list can now be sorted.

.

How you sort the data depends on your desired approach. You can sort the data in order of probable impact. (This sort order will put the risks with the greatest potential impact to your business at the top of the list.) Or you can sort the data in order of probability of occurrence. (This sort order will put the risks that are most likely to occur at the top of the list.) Each sort order has its benefits. Personally, I look at the data in both ways. I obviously want to deal with the biggest impact risks. But I also want to deal with the most probable risks. Call it selfish, but I like the idea of reducing my future stress levels by eliminating the most probable risks.

.

So we’ve got a sorted list of risks. It’s probably somewhat overwhelming. There is no way you can deal with all of them. Where do you start? Which risks do you work on and which do you leave alone? That’s where the 80-20 rule comes in…

.

The 80-20 Rule (aka Pareto Principle) is nothing short of amazing. It says that 80% of the effects come from 20% of the causes. The 80-20 rule applies in many places, but let’s talk about how it can help you out with your risk management.

.

Look at your risk inventory, sorted in order of impact. Count the total number of risks. Now take 20% of the total number. Add up the probable impact of those top 20% of risks and you’ll see that it accounts for about 80% of the total probable impact. Think about that for a minute…. You can address 80% of your total risk exposure by working on 20% of the risks facing your company. How cool is that? If you have 50 risks identified, you can address 10 of them and cover the lion’s share of your risk exposure. Now it’s not so overwhelming, eh?

.

So now we have a manageable number of risks to think about and plan for. That leads us into the final step of risk management – planning for your risks. That will be my topic for the next how-to posts.

.

Coming up

So far, I’ve done a lot of writing about how to do practical business risk management. That’s all fine and good, but I know it’s difficult to apply how-to text to real life. Over the next few weeks, I’m going to introduce you to Fred. Fred owns his own coffee shop and actively manages his risks. I’ll share some of Fred’s experiences with you and show you his risk management spreadsheet. I think the example will be helpful in seeing how all this information I’m spewing at you can be applied in your business.

.

Also in the works… I think it would a glossary of terms might be helpful. I use a lot of terms that can be confusing. Plus some of my terms are “tom terms” – a little different than the industry standard, but easier to understand (in my humble opinion). The glossary will be a living page on the blog. Stay tuned…

.

What else would you like to see from me? Is there different content or more of a certain category that you want to see? What can I do to help? I’m happy to accommodate. Let me know your opinion.

.

Disclosure: I now have a disclosure page. Click here or click the “Disclosure” tab at the top left of the page to read my full disclosure that I really have nothing to disclose.

First off, let me apologize for the inconsistent posting lately. The holiday and vacation really hosed up my editorial calendar…
.
So let’s get back to evaluating risks. In the last post, I introduced you to the first two steps in risk evaluation: estimating probability and estimating potential impact. The last two steps are calculating probable impact and testing sensitivity.

.

NOTE: These evaluation steps only apply if you estimated potential impact in terms of currency (e.g. dollars, pounds, yen). If you used buckets for potential impact, these steps don’t have any meaning…

.

Calculating Probable Impact

Do you remember how I described probable impact? (Here’s the original post.) The probable impact calculation is a way to mathematically calculate an amount to set aside to cover an uncertain event. (Richard Worzel describes it as “expected cost”.) The calculation is super easy – just multiply each risk’s estimated probability by its estimated potential impact.

EXAMPLE:

Joe has identified a risk that a competitor might open up a Starbucks just down the street from his coffee shop. Joe has estimated that the probability of the risk occurring is 50% and, if it does occur, his cash flow will be reduced $100,000. The calculated probable impact of the risk is then $50,000 or 50% x $100,000. Joe decides to set aside $50,000 in a savings account as contingency funding to cover the risk’s impact.

.

Make sense? OK, let’s move on to sensitivity analysis…

.

Sensitivity Analysis

In order to perform a sensitivity analysis, it is necessary to have some type of financial model where you can input different assumptions and evaluate the resulting impact. When I do a business plan or forecast, I set up a spreadsheet. The spreadsheet has a list of assumptions (e.g. # of units sold, average price, average cost, assumed overhead cost components, etc.) and uses formulas to calculate the revenue, profit and cash flow for each month. The model then allows me to do “what if” scenarios.

.

“So why do I want to do a sensitivity analysis?”, you might ask. Well, there a couple of reasons. First off, your estimated potential impact and estimated probability are just that – estimates. If you can evaluate a a range of potential impacts or probabilities for each risk, you can determine a range of contingency funding necessary to cover your risks to the level appropriate to your risk tolerance. Another reason for doing sensitivity analysis is that it provides insight into how your business runs. As you cycle through checking the sensitivity of each of your risks, you’ll find that your business is more sensitive to some than others. Here’s why… some risks impact your business in multiple ways so there is a compounding effect.

.

EXAMPLE:

Fred  has identified two risks for his retail business: a risk that a competitor opens down the street and takes away some of his customers and a risk of stocking poor quality merchandise. The potential impact of a new competitor is pretty straight forward – his daily customer count decreases, reducing his average daily sales and cash flow. The potential impact of poor quality merchandise affects his business in multiple ways. First Fred has to deal with the expense of product returns. Then there is the additional inventory cost to purchase additional product to cover the rejected items. There is also additional labor cost associated with doing a closer inspection of new product received from his distributor before he puts it on the shelf. And probably most importantly, there is the reputation cost of each dissatisfied customer telling ten of their friends about their poor experience.

.

Do you see how the compounding effect works and how some risks can have more impact on your business than others? So here’s how you perform sensitivity analysis. First, for each potential impact (or probability, if you prefer), estimate a range instead of a single value (e.g. Instead of using $100,000 as a potential impact, use $85,000 to $100,000). Calculate a probable impact (probability multiplied by potential impact, remember) for each extreme of the range. Look at the difference between the two values. You will see that some risks have large differences and some have smaller differences. If there is a large difference, that indicates that your business is particularly sensitive to the assumed impact (or probability) and it will be worthwhile to pay a little more attention to that particular risk.

.

WARNING: When doing a sensitivity analysis, create a range for each estimated probability or each potential impact, but not both.

.

As I wrote in Part I of this series, sensitivity analysis is an advanced method. It isn’t required to have a solid risk management program. Sensitivity analysis provides a way to fine tune your understanding – and management – of your business.

.

That’s it, the four steps of risk evaluation. Does it make sense? Do you see how calculating probable impact can help you determine a level of contingency funding and insurance necessary to cover your risks? Do you see how sensitivity analysis might cause you to manage your business differently? What’s your opinion about the usefulness of risk evaluation?

As you recall, the 3 steps of business risk management are:

1. Identify your risks
2. Evaluate your risks
3. Plan for your risks

I’ve written a couple of posts (here and here) about the first step – identifying risks and creating your risk inventory (list of risks and opportunities). I’ve also written about the related topic of identifying your opportunities. It hasn’t been an exhaustive tutorial, but hopefully there has been enough information presented to help you gain a basic understanding of how to get started.

.

Now let’s start talking about evaluating the risks. (Note: Whenever I write “risks” in this post, I am also referring to opportunities. They are evaluated in exactly the same way.) In this post I’m going to describe what results from the risk evaluation exercise. The next post will get into the specific actions involved in the evaluation.

.

Why Evaluate Risks?

The risk evaluation yields several important results. When you are done, you will have

1. A prioritized list of your risks and opportunities
2. An estimated amount of contingency funding required to cover the most important risks to your business
3. An understanding of how sensitive your business is to each of the most important risks.

The most important output is the prioritized list, but the contingency funding level and sensitivity analysis provide very useful information. If you have to cut corners stop after #1, but I would encourage you to work towards implementing all three evaluation steps.

.

Prioritize Risks and Opportunities

The first step of risk evaluation is to create a prioritized list of your risks and opportunities. We will accomplish this by estimating the probability of each risk’s occurrence and estimating the potential impact of each risk if it does occur. You will be able to sort your risk inventory in order of probability (the risks most likely to occur at the top) or in order of potential impact (the risks with the largest potential impact at the top). You may want to focus on the most probable risks or the risks with the largest potential impact – it’s your call. Or maybe you’ll want to look at it both ways. (This is where the advantage of a computer spreadsheet or risk management software comes in to play. A spreadsheet gives you the freedom to slice and dice the data in many different ways.) Now you can focus on just the few most important risks when we move into Risk Management Step #3: Planning For Your Risks.

.

Estimate Contingency Funding Requirements

If you have financial models available that allow you to generate some realistic potential impact values, risk evaluation will allow you to calculate the amount of contingency funding needed to cover your most important risks. The contingency funding will be based on the concept of “probable impact”. Probable impact is calculated by multiplying the risk’s probability by its potential impact. It is a way to mathematically estimate how much money should be set aside to cover uncertain events.

.

Here is how it works. We have a risk with a potential impact of $100,000. That means if the risk occurs (100% probable, right? – it is occurring), the impact on the business is $100,000. But what if the risk’s probability is only 50% – how much should I set aside to cover it? The conservative answer is $100,000, but that’s a lot of money to set aside for only a 50% chance of needing it. Using the probable impact calculation, we would put aside $50,000 (50% x $100,000). Granted, we’ll have some trouble if the risk occurs but not as much as if we hadn’t set anything aside. And remember that we have a list of risks, each with their own probability. Some will occur, some won’t, so at any given point you will have ‘extra’ money set aside that you can draw from. If you keep your risk inventory and evaluations current, you will have a real time estimate of contingency funding necessary to cover those risks you consider most important.

.

Analyze Sensitivity

The sensitivity analysis portion of risk evaluation requires some sort of financial model to test scenarios using your most important risks. Sensitivity analysis helps you understand how sensitive your business is to a particular risk. For example, you have identified a risk that material costs may be $10 per unit higher than planned. You have estimated that the potential impact of the higher material cost risk is $25,000. But your $10 estimate is just that – an estimate. What if the actual material costs are only $5 higher than planned? or $15 higher than planned? Does the risk’s potential impact change a lot or a little?You will find that your business is more sensitive to some risks than others. Sensitivity analysis allows you to identify risks whose potential impacts change more drastically as you move away from your assumed value. It’s definitely a more advanced aspect of risk management that helps you manage your risks more efficiently.

.

Those are the three outputs of a thorough risk evaluation. The concepts can be a little confusing at first (especially the last 2), but give it some time to sink in. The next post will cover more of the step-by-step, how-to details. In the meantime I would love to hear your questions, comments or complaints if I’ve completely lost you.

I was thrilled to read Tim Berry’s November 12 post in his Planning Startups Stories blog. He was talking about 5 basic entrepreneurship skills that business schools don’t teach. One of the skills Tim listed was risk management. He wrote:

I don’t mean the technical side of risk management. Business schools are generally excellent at teaching the numbers and analysis of risk, mathematical tools to evaluate the time value of money, for example, and formulas to compare technical investment risk like the internal rate of return (IRR).

.

I do mean living with risk. Not betting things you can’t afford to lose. How to sleep at night when your customers owe you enough to destroy you simply by failing to pay what they owe. How to figure out which spend is a reasonable risk for generating a future payback, and which isn’t. How it feels to take a second mortgage, or how it feels to tell a graduating high-school senior with a great record that there isn’t enough money for the college he or she has earned.

The risks Tim described are what I’ve termed “Business Risk” (creative, eh?).  Business risk management includes more than insurance and hedges. It is the continuous, active consideration and planning for all of the potential good and bad things that could happen to your business. The process doesn’t have to be formal or sophisticated. Expensive software and consultants aren’t required. Managing business risk is a simple process. But, it’s a simple process that consumes entrepreneurs (whether they realize it or not) and should consume owners/managers of established businesses. In fact, maybe the day-to-day effort invested in risk management is what defines the “entrepreneurial spirit”.

.

How do you feel about that last statement? Agree? Disagree? Tell me why.

Most people think that risk management only deals with the potential bad things that could happen to your business. What a huge misconception. A key outcome of risk management is the identification of your opportunities, too. Very few businesses actively manage their opportunities, but those that do stand out above the rest in terms of growth and profitability. If you put just a little bit of effort into it, you can join the ranks of the best managed businesses.

.

As I wrote a while back, businesses make a lot of assumptions. Almost all assumptions are wrong, which means that the actual result may potentially be worse than the assumption (a risk) or may be potentially better than the assumption (an opportunity). Opportunities can be identified and managed in exactly the same way as risks…

.

Think about that. Opportunities can be managed in exactly the same way as risks. That means opportunities can be identified, evaluated and planned for. How awesome would it be to have a prioritized to-do list of ways to improve your business? Pretty awesome right? We can make it happen…without doing anything more than the normal risk management steps.

.

I’ve already written about how most risks are based on assumptions – conscious assumptions or unconscious assumptions. Most opportunities are based on assumptions, too. For example, you may be assuming a certain raw material or wholesale cost for your product. The risk is that the cost is higher than assumed. But the opportunity is that the cost is lower. The question is how can you make that happen? Another example: A competitor moves in down the street. The obvious risk is that the competitor takes away some of your business. But what if you step up and beat the competitor? What a great opportunity to create word-of-mouth advertising and a great reputation.

.

Good managers are constantly looking for opportunities. Seth Godin (Seth’s blog) and Jeff Cornwall (The Entrepreneurial Mind) both recently wrote about the importance of watching for opportunities.

Seth wrote:

As you get bigger and older, are you busy ensuring that a bad thing won’t happen that might upset your day, or are you aggressively investing in having a remarkable thing happen that will delight or move a customer?

Jeff wrote:

The most successful entrepreneurs are not necessarily those who write the best business plan. What successful entrepreneurs are good at is listening to their customers and then adjusting appropriately.

Both are talking about looking for opportunities.

.

So here’s the point. As you’re brainstorming on all of the risks facing your business, include the opportunities as well. For each risk category and assumption ask yourself “What is the potentially good thing that could happen to my business?” Opportunities are every bit as important to the future of your business as the risks.

.

So how are you doing? Feeling overwhelmed or kinda getting the concept? Hang in there. We’ve covered the basics of the first step of the risk management process: identify your risks (and opportunities). Coming up: evaluating your risks and opportunities.

.

What can I do better to help you out? Post a comment of contact me on the Contact Me page.

About a week ago we talked about how to identify your risks. I asserted that “almost every risk comes from assumptions” and we, as business owners/managers, make A LOT of assumptions. Where do we start?

.

It may be helpful to think about all of those assumptions and associated risks by breaking them down into 3 broad categories.

.

1. Budget (financial) Risk
2. Schedule (calendar) Risk
3. Quality Risk

.

Let’s take a brief look at each of them…

.

Budget Risk

I think it’s fair to say that budget risk is the first type of risk that comes to mind for business owners and managers. A budget risk is any risk that potentially impacts your financial performance. Some potential budget risks are: The risk of a new lower priced competitor entering the market; the risk of an economic downturn changing your customers’ spending habits; or the risk of a key supplier increasing your material costs. Pretty straightforward, right? Budget risks can lower your sales, increase your expenses or do other nasty things to your financial statements.

.

Schedule Risk

Schedule risk can take several forms. It can be in the form of a cash flow risk. Examples are the risk of your customers taking 2 weeks longer than expected to pay up or your supplier insisting on cash up front instead of net 30 terms. Your overall financials really wouldn’t change much, but your cash flow would be impacted.  Another form of schedule risk can be an “external party” risk. An example here might be the risk of a state agency being slow to issue a sales tax permit or business license (a real stretch, right?). Or it might be the risk of a contractor slipping the schedule on a remodeling project. Do you see the distinction between schedule risk and financial risk? Can you think of other forms of schedule risk?

.

Quality Risk

The Quality Risk category is the murkiest category to work with. In my experience many quality risks can be flowed down to financial risk so some judgment is required. Quality risk examples range from the obvious (e.g. the risk of increased warranty expense due to poor product quality or the risk of decreased sales due to poor customer service) to the more obscure (e.g. the risk of a poor first impression due to misspellings in marketing materials or the risk of a poor website design increasing your shopping cart abandonment rate). A good place to start with identifying quality risk is to think about anything that could impact your business’ reputation or your customer’s experience.

.

It’s important to keep in mind that the categorization of your risks isn’t critical to your risk management success. The categories are just guides. They help break down the overwhelming universe of risks into more manageable buckets that you can get your head around. You will come up with some risks that fit into more than one category. Don’t worry about it. Just pick a category and move on. Getting the risks listed somewhere is far more important than the actual category assignment.

.

Can you think of other categories of risks? I’d love to hear your thoughts on them.

“How does somebody develop a passion for business risk management?”, one might ask. Well, let’s just say that I  learned its importance the hard (read “expensive”) way.

.

My partner, Phil, and I started a retail liquor store in our hometown – a small town in eastern Iowa. We did our research. There was a  limited local supply – only the town’s grocery store offered a very sparse selection of liqour, beer and wine with zero customer service. Our interviews with competitors, potential customers and suppliers all indicated that there was a solid market for the business as long as the prices were reasonable. We wrote a kick-ass business plan (”Best I’ve ever read”, said the banker), got our financing, set up our space and opened the business.

.

The initial response was pretty encouraging. We had a great location and put together a nice marketing campaign to generate interest. The business was cash-flowing and life was good. But after about six months, we noticed sales starting to drop off. At first we attributed the drop to the end of the honeymoon every new retail business experiences, but the sales kept dropping off. Phil and I tried a lot of responses – increased marketing, special promotions, PR events, added services, expanded selection – but nothing seemed to stop the bleeding. We finally resorted to what we should have done in the first place…we started asking questions.  Our friends and former customers told us that the convenience of picking up their liquor, wine and beer while they were grocery shopping was more important to them than a better selection, better service and cool setting. Phil and I had assumed that a reasonably priced better selection with better service would win customers over. We assumed wrong.

.

After about three years it was apparent that the business was never going to hit our target returns unless we made some major investments, and even then the returns would be questionable. We elected to close the business down and take the financial hit instead of throwing good money after bad.

.

As we did a post-mortem on the good idea that didn’t work, it was clear that the bad assumption contributed to the loss. But the real cause of our loss was that we were not prepared when a key assumption didn’t pan out. As I’ve written before, assumptions are risks. We could have avoided the financial loss if we had managed our risks up front.

.

We learned our lesson. Can you think of a similar situation? I’d love to hear about it.

Risk management is arguably one of the most under-utilized business tools available to owners and managers today. It involves planning for potentially bad events before they happen. Risk management is a technique for predicting what unplanned events might occur and what the impact of those events might be. It’s also a technique for pre-planning how those events can be avoided or how their impact can be minimized. Almost every business does a limited amount of risk management – usually in the form of insurance – but very few businesses actively manage their risks.

.

So what kind of risks am I talking about? They run the gamut. The insurance I mentioned usually deals with financial risks associated with natural disasters, fire, injury or death, accidents, etc., but there are many, many more risks facing your company.

.Basically every assumption a business makes is a potential risk. Businesses make a lot of assumptions every day, so there are a lot of risks. Here are some examples:

• A highly publicized customer service failure
• A lower priced competitor entering the market place
• A large increase in raw material costs
• Lower than expected response rate to a key marketing campaign
• An economic downturn

Starting to get the idea? But risk management isn’t all about the bad things that can happen. It also addresses the good things that can happen to your business – a.k.a. opportunities. If you have an assumption there are two possibilities if your assumption doesn’t pan out. The possibility of the actual result being worse than the assumed value is the risk. The possibility of the actual result being better is the opportunity. Make sense? Some example opportunities are:

• A highly publicized customer service success
• A lower priced competitor goes out of business
• A large decrease in raw material costs
• Higher than expected response rate to a key marketing campaign
• An economic recovery

.

The concept of risk management is pretty simple – only 3 basic steps:

1. Identify the risks,
2. Evaluate the risks
3. Plan for how to avoid the risks or how to deal with them if they occur.

.

Risk management can be applied to any type of planning you might do – business planning, strategic planning, financial planning, market planning, product planning, etc. The technique is the same for all of them, only the risks and planned responses change.

.

You can make the risk management process as simple or as complex as you want. It can be a spreadsheet with automatic formulas, fancy formatting, etc. or it can be a spiral notebook with pencil entries. The mechanics of how you do risk management aren’t as important as the thought that you put into it. Dr. Jeff Cornwall recently wrote a very eloquent piece about the importance of business planning that nicely sums up how the thinking provides benefit.

Our actual path in our business will likely look very different than our plan. But the plan got us thinking. It made us think about all the details. It helped us understand how all of the parts of a business fit together to make a whole venture. It helps prepare us for our journey and makes us better prepared to adjust to all of the surprises that we will face almost every day we’re in business.

Risk management is the specific method that helps better prepare us for those surprises that are sure to happen…

.

This blog is dedicated to business risk management. In the future I will write about how the technique can be applied in different ways and the detailed step-by-step instructions on how to do it. Every now and then I’ll write about examples of risk management in current events to show how it’s being used (or should have been used) in real life.

.

I’m glad you have joined me. I’m looking forward to our discussions on how risk management can contribute to your business’ success.  Do you see the possibilities? Stay tuned…