Manage the risks and the rewards take care of themselves.
I define Risk is “a potentiality which, if actualized, presents an adversarial outcome for the enterprise.”
Risk Management, for me, consists of “working in a systematic way to reduce the probability that those adverse potentialities occur.”
At Scrapbook.com we manage risk in a systematic way. Risk management isn’t something that’s ever “done”. We manage our risk cyclically in that we go through our risk management processes in order, and then once we’ve gone through them, we do them again, and again, and again, ad infinitum. Over time, I came up with the areas of risk we manage, and then made an acronym out of them which captures the cyclicality of the risk management process:
CIRCLES.
C – Customer Experience
I – Inventory
R – Resources (Human)
C – Capital Structure
L – Liquidity and Legal (these really don’t have anything to do with each other, but I didn’t like the way CIRCLLES looked!)
E – Expenses
S – Sales
There are things our company does daily, weekly, monthly, and yearly, in each of these categories. For example, here’s one specific thing (of dozens, or even hundreds) we do in each category.
Customer Experience – Perform website navigation audits. We test the site for broken links, unclear or incorrect language, general functioning of apps, bug testing, etc. and fix any problems areas immediately to mitigate the chance that a potential customer will abandon our site because they do not “trust” it do to our carelessness or because they are frustrated because they cannot find what they’re looking for.
Inventory – Review supplier fulfillment metrics and take action when they’re out of whack. We want our suppliers to keep us stocked at all times. Our internal algorithms tell us when we need to order product in order to keep levels in stock. These algorithms depend on fulfillment consistencies from suppliers. We don’t care so much that they ship slow or fast (though we prefer fast) – our algorithms can adjust to that – but we do care that they are consistent because if they are not, our algorithms can’t tell us the right quantities to buy and when to buy them, and therefore we’ll end up either over or under stocked. If we’re overstocked it is tying up capital we can use elsewhere. If we are under-stocked, we lose sales. So, in a very real sense, our suppliers can cost us money by tying up our resources inefficiently and losing us chances to serve a customer. If we are seeing inconsistency with a supplier, we’ll either put them on notice to improve, or we’ll move business away from them and toward more consistent companies (even up to the point of discontinuing business with a supplier).
Resources (Human) – Review employee turnover. Employees leave because they are either unhappy, or they have better opportunities elsewhere. When employees leave, all their experience and knowledge walks out the door with them. Training new employees and getting them up to speed is very costly for us. When employee turnover ticks up, we seek out the cause and nip it in the bud.
Capital Structure – Review the capital stack and maximize the returns to equity without taking on undue debt. Low-interest debt is “good” because by using it we can – among other things – extract equity from the company (through recapitalization), lower taxable earnings (b/c we can expense interest payments), and lever the return that the remaining equity sees (capture spreads between the cost of the debt and the return on the invested capital). Debt is “bad” because repayment terms are not flexible and because it requires collateralizing productive assets, putting their ownership at risk if we fail to comply with the debt terms. Too much debt can hamstring or burden an organization. We constantly review our ratio of debt to equity against our current and projected needs, and adjust accordingly.
Liquidity – Monitor the ratio of sales to cash and as sales increase, increase cash on hand. Increasing sales means that inventory needs will increase. Inventory increases mean accounts payable increases. Accounts payable increases means increasing cash on hand in order to keep the inventory turns from being interrupted. So many retail businesses are tempted to extract cash when sales go up (“We’re making so much money! Let’s pull out money out from the business and buy a yacht!”), yet that’s the worst thing they can do – they INCREASE risk. Growth requires financing. Many retail companies grow themselves right out of business. By increasing liquidity and resisting the urge to extract cash while growth is occurring, businesses REDUCE risk. This also means that you have to strike a careful balance between how much of your retained earnings you allocate to inventory and how much you retain to ensure you can keep your payables turning and keep your product in stock. We have a ratio of sales to cash that is ideal for the smooth functioning of our business and we are disciplined about maintaining it.
Legal – Keep a list of legal obligations and comply with them; keep a list of counter-party obligations and require compliance . When you sign any contract with any person or business, you are obligating yourself to some performance, and so are they. In order to ensure that you do not put your business at risk by breaching an agreement, keep a list of all the contractual agreements you’ve made and comply with them. Also, to ensure that you do not put your business at risk by contractual parties failing to comply with their side of the agreement, keep a list of what they’ve agreed to do. If they do not comply, pursue legal remedies as appropriate. Failure to do so may be much more costly than allowing their non-compliance to hurt your business. (A quick anecdote about my failure to record others’ legal obligations. I executed a contract some time ago, and in the contract there was some language that after three years time the counter-party was to pay us $8,000. I neglected to note this. Three and a half years later, I was reviewing the contract and noticed this clause that I had forgotten about and the counter-party had not complied with. I wrote the counter-party and they immediately paid us [as they were in breach of the contract], yet my failure to note this in the first place meant our business went six months without $8,000 it should have had. Had I not re-reviewed the contract … well, let’s not go there … The point is, the counter-party exposed themselves to legal risk by not complying with the contract, but I exposed us to financial risk by not taking the necessary steps to ensure counter-party compliance in a timely way).
Expenses – Constantly review expenses to ensure that they are both necessary and in line with the market. This process never ends. We look at every expense as an “investments” and define what the “return” on that investment will consist of (i.e. what value comes back to us for having the cash outflow …). We ask, “If we eliminated this expense, what value would be lost?” And then we also ask, “If we increased this expense, what would be the increase in value?” By looking at expenses as investments in value (and we note that some value is intangible but ultimately should feed into a tangible value return), you start thinking like an investor and act as a more careful steward of your resources.
Sales – Are we making more sales or making less sales, and what are we “giving up” to make them? Profit is the difference between the value you add to the world (in the form of revenue that people reward you with for giving them a good or service) and the value you take from the world, (or the resources you consume to deliver your good or service, i.e., expenses). You have to make sure that you aren’t delivering goods and services that are providing less value to the world than the value they’re consuming to do so. By looking closely at those sales and making sure they’re net-value adds, you’ll lower failure risk for the business. I like to say that I can generate a billion dollars in revenue tomorrow, just give me a billion and one dollars to spend on it today! What’s a lot tougher than that is to take $9 of investment/expense and turn it into $10 of value. That’s the trick!
I hope this post is helpful and that you can take CIRCLES and implement it into your organization, thinking systematically about the adverse outcomes that can affect you. Put into place a cyclical system that helps you monitor and mitigate those adverse potentialities.