A:

Before a business can assess or mitigate business risk, it must first identify probable or likely risks to its bottom line. There is no surefire method for identification or assessment, but firms rely on reasonable approximations based on past experience. Risk processes naturally evolve and mature over time, but there are some fundamental principles that stay constant.

Business risks come in all shapes and sizes, so effective risk assessment must be adaptable to or uniquely designed for specific dangers. Whenever possible, a firm should group similar risks into similar analytic processes.

Ideally, a company should allocate capital based on risk in conjunction with cost/benefit analyses. Every risk identification process should lead to effective analysis, and every analysis should inform corporate governance.

Internal Vs. External Risk Analysis

There are two broad forms of risk: internal and external. External risks are those that originate outside of the firm and include economic trends, government regulation, competition in the market and consumer taste changes. Internal, or firm-specific, risks include employee performance, procedural failure, and faulty or insufficient infrastructure.

External risk assessment is almost always data-heavy. Since most external risks are systemic to an economic system – and therefore outside of the control of the company – forecasts cannot be adjusted based on different corporate governance decisions.

The external assessment begins by categorizing potential risks. Some scales are nominal, and some are ordinal. Companies prefer nominal categories because they are easier to manipulate and compare. Quantitative techniques, such as benchmarking or probabilistic modeling, adapt to new data as it arrives. Companies can then track relevant indicators and create thresholds of acceptable risk for a given project.

Internal risks under far more specific and controllable processes. Companies use operational risk assessment for risk of loss from inadequate business decisions. Compliance risk assessment is crucial, particularly in tightly controlled industries, such as banking or agriculture. Internal audit risks must be assessed, particularly for publicly traded companies.

Modern companies assess internal risks by considering likelihood and impact to specific objectives; it wasn't that long ago that companies simply operated on industry-standard practices.

RELATED FAQS
  1. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
  2. How are risk profiles and speculation related?

    Learn more about risk profiles and speculation, why speculators should assess their risk profiles and how risk profiles and ... Read Answer >>
  3. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
  4. How does market risk differ from specific risk?

    Learn about market risk, specific risk, hedging and diversification, and how the market risk of assets differs from the specific ... Read Answer >>
  5. What are the differences between internal and external economies of scale?

    Take a deeper look at the differences between internal and external economies of scale, and learn why internal economies ... Read Answer >>
  6. What are the risks associated with investing in the banking sector?

    Find out about the risks associated with investing in the banking sector including liquidity, risk management, consumer protection ... Read Answer >>
Related Articles
  1. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  2. Insights

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  3. Investing

    Explaining Operational Risk

    Operational risk is the risk that a firm will fail or lose money due to failed internal processes.
  4. Investing

    Balancing the Different Risks Investors Face

    One of the keys to investing successfully is to balance different types of risk.
  5. Tech

    The Importance of Healthcare Risk Management

    Risk management is especially important in healthcare because human lives might be on the line. Here are some strategies to map out a plan.
  6. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
  7. Investing

    Understanding Market Risk

    Market risk is the chance that an investment’s value will decrease due to a factor that affects all investments across the market.
  8. Personal Finance

    What Does It Really Mean to Be Risk Averse?

    We can’t really get away from risk and there are many meanings for this thing we call risk.
  9. Small Business

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  10. Financial Advisor

    Pro Tips on Evaluating Clients' Risk Tolerance

    Want to keep clients longer? Bolster your risk assessment capabilities.
RELATED TERMS
  1. Risk Assessment

    The process of determining the likelihood that a specified negative ...
  2. Accepting Risk

    A risk management method used in the business or investment field. ...
  3. Country Risk

    A collection of risks associated with investing in a foreign ...
  4. Specific Risk

    Risk that affects a very small number of assets. Specific risk, ...
  5. Risk Profile

    An evaluation of an individual or organization's willingness ...
  6. Market Risk

    The possibility for an investor to experience losses due to factors ...
Hot Definitions
  1. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  2. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  3. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  4. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  5. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  6. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
Trading Center