Corporate Finance For Dummies
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Operating risk, or operational risk, is the risk of losses or costs associated with business operations. According to the Basel Accords on banking supervision, this category includes just about every possible non-value-added cost that a company can experience — from fraud and theft to negligence and stupidity to accidental events such as the acquisition of faulty equipment or the occurrence of a natural disaster.

Operating risk is the probability of any non-value-added costs being incurred as a result of a company’s internal operations, systematic or not. Here are two quick examples, including how to reduce the associated risk.

Assume that earthquakes can’t be predicted. That said, any company that sets up operations in an area known for having earthquakes is subject to the risk of losses and costs associated with earthquakes.

That doesn’t mean setting up in an earthquake area is a bad thing; it just means that the company must assess the potential losses associated with earthquakes in that region and determine whether it can earn enough revenues to make up for those costs.

Financial management can’t do much to mitigate the risk of earthquakes except, perhaps, purchase insurance. Financial analysis, however, can provide information about whether the benefits of locating a company in an earthquake zone compared to the next-best choice surpass the expected costs associated with purchasing insurance, repairing damage, and potentially even rebuilding completely.

In the second example, financial management can actually help to identify the problem. Say a company isn’t operating as efficiently as it should be but no one can figure out why. Management must bring in the finance department to be detectives!

Any halfway decent financial analyst can trace the intra-organizational cash flows, meaning that he can break down every function of the company and account for the costs incurred by each department compared to the movement of cash between departments.

The analyst might discover that money is being lost in the marketing department that isn’t accounted for in its expenditures and that a computer has been hacked that’s allowing an employee to embezzle money from the marketing budget. Performing internal audits like this helps companies to reduce losses from operating risk.

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Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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