Profit risk is an approach to risk management that focuses on measuring specific items found on an income statement and determining the degree of risk that is associated with those items. The idea is to evaluate the impact those items have on the overall net income produced for the period under consideration and decide if the risk factors associated with those line items is in line with the generated returns. Typically, this approach is used in tandem with other risk management tools that help companies to evaluate credit risk and conduct asset liability management in a responsible manner.
With a profit risk, the goal is to makes sure that all items accounted for on an income statement are carrying an acceptable level of risk, with the returns are consistently sufficient to justify incurring that risk. Assessing profit risk on an ongoing basis is often a good idea, since a number of external factors may cause a shift in the degree or risk associated with those line items, possibly to the point that the risk level is no longer considered to be in line with the returns. When this occurs, the company has the opportunity to move quickly to correct the situation and protect the overall level of net income to the business.
Careful consideration of individual line items as well as groups of line items is key to the process of assessing profit risk. It is important to note that simply looking at the bottom line of the income statement is not sufficient, since a company can actually be increasing net income while the profit risk associated with specific items is also increasing at a pace beyond that of the increase in income. Risk factors that are subject to change include shifts in the customer base, changes in product costs, and even changes in the sales force.
For example, the total income generated by a specific sales region of a national retail firm may be increasing, even though one or two stores within that region may be losing market share rapidly. If the profit risk is assessed on the region, it is possible to identify the shift in income levels generated by those declining stores. Depending on the number of stores or delivery channels operated within the area immediately surrounding those declining stores, the business may decide to close those stores, with the anticipation that customers will simply shift their business to the other locations of the same retail firm within the area. When this holds true, the business effectively stops the losses generated by those stores while still maintaining that income flow in the form of increases at the surrounding stores.
Assessing profit risk can often aid in the process of asset allocation, allowing a business to make the most prudent use of assets in the process of generating revenue. By identifying weak links in the overall income generation strategy, it is possible to shift asset to more profitable areas that are very strong and capable of sustaining growth over an extended period of time. Doing so may or may not have any immediate impact on the net income generated by the business, but is likely in the long run to strengthen the position of the company within its industry and help the business hold that position for a number of years.
