Risk Rating

Updated on April 19, 2024
Article byAbhilash Ramachandran
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Risk Rating?

Risk Rating is assessing the risks involved in the daily activities of a business and classifying them (low, medium, high risk) based on the impact on the business. It enables a business to look for control measures that would help in curing or mitigating the impact of the risk and, in some cases negating the risk altogether.

What Is A Risk Rating

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Risk Rating (wallstreetmojo.com)

When the risk cannot be mitigated or negated, the business has to accept that the risk is open and there are no control functions to curb the impact. It depends on the likelihood of the risk event occurring and the severity of the impact on the business and its employees.

Key Takeaways

  • . The risk rating assesses and categorizes the risks involved in a company’s daily operations (low, medium, and high risk) based on their impact on the firm.
  • It assists a corporation in seeking control techniques that will aid in curing or minimizing the effects of the risk and, in some instances, altogether eradicating the risk.
  • It is a complicated procedure that needs a high degree of skill and foresight to anticipate possible hazards that might jeopardize the smooth operation of the firm.

Risk Rating Explained

The risk rating matrix refers to the classification of risks and their impacts on the business regarding reputational or economic damage to an organization or a sector. Through this method the organization evaluates the level of risk and identifies it with a particular part of the organization or an investment project or an individual. In the process, various factors that may influence the risk levels are determined to assess the impact and the likelihood of the risks.

Organizations should consider conducting at least a yearly risk rating review due to the fast-paced business environment.

Any risk rating formula enables a business to be well informed about all the potential risks that can cause an impact on the business, along with the likelihood of the event’s occurrence. However, the criteria for rating the risks of the entity and the various methods to do so vary from company to company or from industry to industry.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Factors

There are some important factors that needs to be considered while rating the risks of a business. They are as mentioned below:

  • Rules and regulations – The management needs to understand and evaluate whether the rules and bylaws set for the smooth running of the business are properly followed or not.
  • Historical data – The past history can give some insight into whether the organization has already faces, some risks, threats and failures in the past, which hints that it is necessary to avoid situations that may trigger such threats again.
  • Vulnerability – It is important to understand the extent of vulnerability of the business to various risk factors, which might be both internal and external.  
  • Impact – The management should be competent enough to judge how severely the risk may affect the business and its impact on the day-to-day operations.
  • Financial stability – It is important for the organization to be financially stable and have the capacity to absorb a certain amount of risk. For that, it should have good profitability levels, high cash flow, and a good brand image in the market.

The company can have a risk rating assessment after taking into consideration the above factors that influence the risk levels. This risk rating matrix helps the decision makers identify and control the risk by using effective strategies and channelize the business in proper direction.

Categories

Risk is rated on the impact on the business, which can be economical or reputational, and its likelihood of occurring shortly. This is the common pattern of risk across businesses.

Impact of Risk Rating

  • Low: A low-rated event is one with little / no impact on the business activities and the reputation of the firm.
  • Low/Medium: Risk events that can impact on a small scale are rated as low/medium risk.
  • Medium: An event resulting in risks that can cause an impact but not a serious one is rated as medium.
  • Medium/High: Severe events can cause a loss of business, but the effects are below a risk rated as high.
  • High: A major event that can cause reputational and economic damage, resulting in huge business and client base losses.

Likelihood Rating

This risk rating formula the risk based on its recurrence, which can change depending on the type of business that is being considered. For example, for a fast-food company, a frequent likelihood rating will be something that can happen every day, whereas, for an investment bankInvestment BankInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more, it would be something that happens in a month or so.

  1. Frequent
  2. Likely
  3. Possible
  4. Unlikely
  5. Rare
Risk Rating Matrix

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Risk Rating (wallstreetmojo.com)

Example

Below is an example of the risk rating assessment based on its impact on the business. The financial impact rating on the business may vary depending upon the business and the sector in which it operates. Businesses with lower income can have $500k as a high-risk event, whereas higher-income businesses will rate it as a low-risk event. The risk rating methodology purely depends on the sector in which the business is operating.

risk rating example

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Risk Rating (wallstreetmojo.com)

Likelihood Rating

likelihood rating

Advantages

Let us understand the various advantages of the concept.

  • Studying the risk involved in a business activity helps in taking appropriate measures to either curb the effects of the risk or eliminate the risk.
  • Event risk helps in a better understanding of the risk and working towards enhancing the current procedures.
  • The quality of the business process and the method or operation drastically improves if the risks factors in an organization is minimise and and controlled.
  • In the competitive market risks like threat of competition, outdated technology, lack of proper and skilled resources is always present. Risk rating helps in identifying ways and means to devise measures to face them and stay ahead of the competition.

Disadvantages

The risk rating methodology also has some disadvantages that should be noted, as follows:

  • This is an assumption of the impact it can have on the business, which, if not done diligently, can cause economic and reputational damage to the organization, resulting in loss of business.
  • This is a complex process and requires a high level of experience and thoughtfulness to foresee potential risks that can impact the smooth functioning of the business.

Thus, it is important to keep both the pros and cons of risk rating in mind and use the process to its optimum capacity so that it yields maximum results at least cost.

Frequently Asked Questions (FAQs)

What is a residual risk rating?

The amount of danger or risk associated with a happening or action that remains after natural or inherent risks have been decreased through risk management is known as the residual risk rating.

What are risk rating factors?

Risk rating models consider a borrower’s health, industry features and circumstances, and macroeconomic considerations, to mention a few. Other variables may include a subjective evaluation of a company’s competitive capabilities, the dependability of management, political concerns, and environmental hazards.

What is a country risk rating?

Country risk is the uncertainty associated with investing in a specific nation and, more particularly, the extent to which such uncertainty may result in investment losses. Uncertainty can be driven by various causes, such as political, economic, exchange rate, or technical impacts.

What are some standard scales for risk ratings?

Risk ratings can be expressed using various scales, but a common approach is to use a numerical scale, such as 1 to 5 or 1 to 10, where higher numbers indicate higher levels of risk. Qualitative scales (e.g., low, medium, high) are also frequently used.

This has been a guide to what is a Risk Rating. We explain it along with example, factors, catagories, and their advantages and disadvantages. You can learn more about accounting from the following articles –