Risk management in SMEs

LAHORE: Risk management culture is generally less prevalent in Pakistan, particularly among SMEs. Large companies, especially those operating internationally, tend to have more structured risk management frameworks.

Risk management is the process of identifying, assessing, and controlling threats to an organization’s capital and earnings. These risks can stem from various sources, such as financial uncertainty, legal liabilities, strategic management errors, accidents and natural disasters.

Many Pakistani businesses adopt risk management practices reactively rather than proactively, often due to a lack of awareness or resources. However, the financial sector and certain export-oriented industries are better at managing risks due to regulatory demands and international standards. Building a proactive culture around risk management ensures that risks are anticipated, evaluated, and mitigated rather than merely addressed after an issue arises.

The cost of managing risk for an entrepreneur depends on the size and nature of the business, the complexity of operations and the risk environment. This includes risk assessment and auditing in the initial phase, where risks are identified, assessed and quantified. Another cost is insurance, which helps mitigate financial losses from specific risks. In today’s landscape, investing in cybersecurity and software to monitor financial fluctuations and compliance has become essential; however, this aspect is generally overlooked by many SMEs. Funds reserved to manage crises or failures ensure the viability of a company during difficult times.

Small businesses or SMEs in Pakistan invest proportionately less in risk management, focusing primarily on immediate concerns like insurance and cybersecurity. In contrast, large companies might have entire departments dedicated to risk management.

Managing capital costs involves employing hedging strategies, such as derivatives to offset interest rate risks, and diversifying financing options to secure better rates. Unfortunately, this strategy is rarely adopted even by larger companies in Pakistan, often resulting in their closure. Stress testing for interest rate hikes or changes in credit ratings aids in financial planning but is rarely practiced.

Large entrepreneurs must stay updated with regulatory changes through constant monitoring or by employing a compliance officer. It is crucial to have contingency plans for shifts in regulations, particularly regarding the costs associated with non-compliance fines.

Local companies are now beginning to invest in cybersecurity systems and encryption technologies. Training employees on data security and implementing strict access controls are integral components of effective risk management.

Risks related to input factors, such as raw material prices and currency fluctuations, are generally easier to manage using financial instruments like futures contracts, hedging, or forward contracts. Currency risk can be mitigated by keeping a portion of funds in stable foreign currencies or operating dual-currency arrangements. Businesses often negotiate flexible supply contracts to address raw material price volatility.

Managing risks related to product failure is more challenging, as it affects brand reputation and market share. Recovering from such failures can be costly. To mitigate product risks, companies should conduct rigorous testing and quality control before launching products and establish robust customer feedback systems and warranty programs.

Risk management must be championed by top leadership, integrating it into the overall business strategy to foster a risk management culture within the organization. Employees should be trained in risk identification and encouraged to report potential risks.

All enterprises should develop a clear policy outlining their risk appetite, governance, and reporting systems. Furthermore, a culture should be nurtured that encourages transparent communication, allowing risks to be promptly identified and addressed.Regular reviews of the effectiveness of risk management practices are essential to making necessary adjustments.