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Capacity and Willingness to Assume Risk

The opportunity for the business to earn a profit requires assuming some risk. Although not described as a business asset, the ability and willingness to assume risk is critical. Types of risk a farm business encounters include production, price, and financial. A farm likely will differ in its capacity to assume each type of risk exposure.

Capacity to Assume Risk

Ability (or capacity ) to assume risk differs from a willingness to assume risk, but either can limit the risk exposure a firm accepts.  Business owners who recognize and prudently use their capacity to assume risk are likely to enhance their chance for financial success.

One way to consider a farm's capacity to assume risk is to describe it as a chain with five links.

• The first link is net earnings as a percent of the value of the firm's gross income, which shows the firm's capacity to absorb losses; in a farm setting, for example, losses that result from reduction in yields or price.
• The second link is the working capital of the business; this indicates if the business has sufficient cash flow (and current assets) to cover operating losses that occur in the first link.
• The third link is current debt repayment capacity, which shows the firm's ability to rely on a carryover operating loan to finance operating losses.
• The fourth link is owner's equity, which is the business' ability to sell assets to restructure its finances.
• The last link is collateral, which is the legal right to the owner's equity.

If any one of these links is weak, so is the chain; that is, the firm's capacity to assume risk.

Related to the ability to assume risk is the desire or willingness to control risk exposure through insurance or alternative strategies. Perhaps one rule of thumb on assuming risk could be "if the activity prevents you from sleeping at night, you may not want to pursue it." Methods of assessing and controlling risk are explored in subsequent discussions.

Willingness to Assume Risk

This question asks business owners to look at themselves and determine how much and what type of risk they are willing to assume. The answer may not be quantifiable, that is, it may not be possible to express in numbers; but it is a factor that must be considered. Some individuals shy away from risk; others are more willing to accept risk exposure.

An individual's attitude toward risk has some similarities with opportunity cost; that is, the level of enjoyment that they receive from the activity will influence how willing they are to accept the accompanying risks. Therefore, an individual's willingness to accept risk exposure may vary among activities.

It is important that each owner perform their own assessment of their willingness to assume risk. The willingness of individuals to accept risk changes over time; attitude toward risk often changes as we and our families grow older. Monitoring attitude towards risk is part of the farm planning puzzle.

Last Updated October 31, 2005

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

E-Mail:sswandal@ndsuext.nodak.edu
Published by Agricusiness and Applied Economics
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