Lexicon
What is risk appetite?
To achieve certain strategic objectives – like more sales in new markets, a merger or an acquisition – an organisation must be willing to accept a certain level of risk; this is known as risk appetite.
How to establish risk appetite
Because the definition of risk appetite is an organisation‘s willingness to take on risk in pursuit of its objectives, to establish risk appetite, the organisation’s board of directors must first examine the organisation’s risk management.
By determining how much risk your company will face, you will know how much effort and resources must be put into managing it and mitigating its impact. This also reduces financial risk.
A classic example of such appetite in action is on display when it comes to acquisitions.
Let’s say there are two businesses for sale. The risk of loss is extremely high for the first business, but the profit potential is enormous if the investment is successful. There is minimal risk of loss with the second, but the profit margin is very small.
Read more: The role of governance in managing risk
Which of the two risks is the best choice?
It depends on the goals of your organisation. For a fixed income and to avoid significant losses, perhaps the latter is the best choice. In contrast, if you are looking for a higher ROI, the first option may work better.
This is how business works. A company’s level of risk-taking guides its decision making.
Risk appetite is also influenced by risk tolerance. If a firm wants to acquire a business, it might accept a higher degree of risk.
However, if the investment is made in an emerging company and there is a possibility of losing half the capital, the company probably won’t follow through on the deal. This is known as risk tolerance.
Read more: A beginner’s guide to risk management
How to calculate risk appetite and tolerance
How an organisation calculates their risk appetite depends on the strategic objectives of each company. For determining risk appetite and tolerance, different factors must be considered, including:
- Financial capacity
- The type of industry the company belongs to
- The risk culture
- The competition
- The organisational objectives and strategy
Furthermore, risk appetite and tolerance depend on circumstantial factors, such as [when buying another business] the budget, the skills of the people involved and the technologies or systems the target company uses.
The board should periodically review risk and tolerance and modify according to changing circumstances.
Watch the video below where board member and chair, Sharon Constancon talks about effective risk management and why board members should alway listen to their senses when it comes to their risk appetite.
