Risk Management – A Case Study on the Consequences of Bad Risk Management
Risk in business is a reality. When these risks are successfully managed the rewards can be substantial. If not, a business can run into serious problems and even collapse. It is unnecessary (and stupid) to ignore risks.
Over more than a decade we advised and assisted companies in growing and managing their businesses. Over time we observed many companies that ran into trouble because they ignored specific risks. This case study focuses on a few companies that each ignored one important aspect of risk management and then paid the price. The discussion is done under the following headings:
- Insufficient planning;
- Bad relationships;
- No hedging;
- Lack of discipline.
Risk is drastically reduced by proper preparation and detailed planning. Planning includes feasibilities studies, business planning, cashflow projections and financial planning.
We were recently approached by Hypothesis Toys to assist them with additional financing. At that stage they were already in dire straits and had invested a small fortune. The company was established to make one specific type of toy. The management made the following assumptions:
- That customers would pay a premium (double the price) on their products compared to other existing products due to the fact that their products look different and was branded with the logos of professional sport bodies.
- That all the major supermarkets will sell their products.
- That the total market consists out of every toddler in the (developing) country that they operate in.
- That they would get 10% of this market within the first year and 50% by year three.
This company did not have a chance from the beginning. The haphazard way that they came to their assumptions was mind-boggling. The market penetration figures were absolutely unrealistic. No research was done to get the real facts (except for the number of toddlers in the country). The scary part of this story is that it is not an isolated incident. Many entrepreneurs, and even established companies, expose themselves to the unforgiving risk of not doing proper market research when they embark on a new venture.
Human relationships can never be ignored. It is potentially one of the most fatal risk factors in a business. Relationships should be nurtured with all stakeholders in a business – including the investors, financiers, suppliers, employees and customers.
A while back one of our clients asked us to handle a possible merger and acquisition on their behalf. They were approached by Fuzzy Manufacturers to buy out their total operations over a few years (they do a lot of business with this company).
The owners of Fuzzy Manufacturers managed some of their relationships during the negotiations as follows:
- They never kept any commitments that they made with us or with our clients.
- They were not transparent with the relevant stakeholders – including the financiers.
- They did not involve their senior management with any aspect surrounding the proposed deal.
The negotiations were finally called of due to financiers that withdrew. Everybody lost their respect for the owners of Fuzzy Manufacturers and some companies are very uncomfortable to do business with them. Eventually some of their senior employees left and joined the competition. Their business became a shadow of what it used to be.
Financial risks (such as currency risk and commodity price risk) can often be hedged with sophisticated products. Operational hedging is also possible (to a large extent) by spreading the risk through a variety of suppliers, products, distribution channels, customers, back-up facilities, etc.
Focused Systems specialises in IT networks. They were exceptionally successful, especially after landing a big national concern. Thereafter they made some serious errors when they did not hedge their operational risks, including the following:
- They focused on this client and regarded all other clients as less important.
- This client contribution grew to more than 35% of their turnover and they were responsible for most of their profits.
- They ceased to do any more international work.
The big national concern became the target of an international listed entity. This group had their own IT specialists and Focused Systems lost the account. The company nearly went under. Fortunately the owners learned from their mistakes and with a concerted effort they broadened their product and service offering, their customer base and their geographic representation. Today the company is really formidable. No customer can keep them ransom due to the fact that not one of them is responsible for more than 5% of the company’s turnover.
Lack of Discipline
There is probably no better way to reduce risks in a business than to be properly prepared and to be well-disciplined. This is true for planning, relationships and hedging as well as for being disciplined in aspects such as keeping a lid on expenditure, to grow within sustainable levels, to not fall into the debt-trap and to manage cashflow with an iron fist.
About a decade ago Expansion Chemicals was very well known and respected in the industry that they operated in. Their vision was to be the market leader. Unfortunately they were not very disciplined and made the following serious mistakes:
- They sold products at any price just to get the sale. Their actual gross profit margins were much lower than their projected margins and their net profitability were very low.
- They grew at an alarming rate that was not sustainable with internal financing or through debt.
- The expenses of the owners (who also managed the company) skyrocketed and it included luxuries such as private planes and sport cars.
Unfortunately this once profitable business failed. The owners are now employees in other companies.
The companies discussed above all basically ignored one specific type of risk. It can only take one unexpected claim against a company, a major customer that is lost or not enough cash to pay a big supplier, to cripple a company. When a business plan diligently, work on all its relationships, hedge its financial transactions and operations as far as possible and work in a disciplined way they reduce the risks in a company tremendously.
Copyright© 2008 – Wim Venter