Calculating returns on project forecasts is an easier task than calculating the project risks.
There are numerous methods for doing this, some very technical and some intuitive.
There’s enough written about the technical methods of evaluating risks, so I won’t go into it. Suffice to say, read anybusiness text book and you can find enough of them, some too esoteric to apply in the real world.
If it wasn’t esoteric the world financial crises in the past would have been avoided. Humans will always over ride risk evaluations when they want to. This is why Behavioural Economics is now becoming important.
So I will go into the non technical methods of evaluating project risks.
However, these have to include risk assessments since there is no point in going for the project with the highest return if that also has the higher risk of failing.
So, here are the 3 key areas you need to assess for project risk:
1. Has it been done before?
Businesses look at launching new products and services all the time and usually they stick to areas they have experience of.
There is still risk but much lower than if you’re starting something completely new. Of course, some companies do this when they think they can do better than all current products in a market sector. The best recent example of this is Apple with the iPhone, which increased their income and profits manyfold.
If it’s a totally new product, then the risks are much higher and every aspect of getting the product ready for market has to be assessed and risk factors drawn up. Many businesses will draw up risk registers with every conceivable risk evaluated with likely outcomes. The larger the capital spend, the longer the risk register.
This is something both the Board of Directors of the company and the project funders would want to see. If a bank islending funds for a project, it will want to see the risk register and also do it’s own due diligence on the project risks.
2. Have you got sufficient resources?
Forecasting cashflows and assessing the man hours required is the relatively easy part. What happens if the project over runs by 12 months? Will you have enough cash to carry on until the finish? Who are the key personnel required to complete the project and what happens if they leave in the middle of the project?
The disaster scenarios can be unending. However, this is the level of detail that is required for every project.
3. What is the economic climate?
When the global economy is in recession, not many companies venture into new areas and many CFOs’ and FD’s would be advising caution. Economic risk can be evaluated country by country and there are agencies that visit countries and prepare economic reports so that businesses can evaluate the specific risks for doing projects in those countries.
Most businesses will evaluate project risks and then allocate a probability to each risk so that an action list can be produced to reduce those risks.
For the decision makers and investors, these risks can also be factored into the financial returns calculations through using higher discount rates for NPV and keeping a ‘risk’ margin on the expected IRR.
Once the decision is made and the project kicks off, events can take over and unthought of issues can make an impact. However, if the preparation is thorough, then these too can be overcome.
About the Author – Asoka Karandawala
Asoka Karandawala is an Independent Finance Director and Management Consultant based in London. He works with growing companies as their part time Finance Director and is the Founder of AKCA Consulting, which helps companies improve their financial health.