Business risk is an umbrella term for the factors and events that can impact a company's operational performance and income. Business risks can hinder a company's ability to provide its investors and stakeholders with expected returns. However, a company can reduce its exposure to business risk by identifying internal risks and external risks.
- Business risk is an umbrella term for the factors and events that can impact a company's operational and financial performance.
- Business risks can hinder a company's ability to provide its investors with expected returns.
- Internal risks include personnel management, such as labor shortages or poor morale and technology issues, such as outdated software.
- External risks include economic slowdowns, leading to lower revenue as well as political risks from trade wars hurting international sales.
How Business Risk Works
Business risk is the exposure a company faces that could eventually lead to lower revenue, profits, and financial losses. Companies face business risks every day, and those risks are part of operating in the segment or industry that the company resides.
Although any factor that reduces a company's operational efficiency or its ability to reach its financial goals is a business risk, it's helpful to categorize them when developing a risk management strategy. Of course, there is no single plan that can eliminate risk, but with proper planning, companies can anticipate risks and respond appropriately. Business risks are typically categorized as either internal or external risks.
Internal Risk Factors
Internal risks are faced by a company from within its organization and arise during the normal operations of the company. These risks can be forecasted with some reliability, and therefore, a company has a good chance of reducing internal business risk.
The three types of internal risk factors are human factors, technological factors, and physical factors.
1. Human-factor Risk
Personnel issues may pose operational challenges. Staff who become ill or injured and, as a result, are unable to work can decrease production.
Human-factor risk can include:
- Union strikes
- Dishonesty by employees
- Ineffective management or leadership
- Failure on the part of external producers or suppliers
- Delinquency or outright failure to pay on the part of clients and customers
A company may need to hire or replace personnel key to the company's success. Strikes can force a business to close for the short-term, leading to a loss in sales and revenue.
Improving personnel management can help reduce internal risks by boosting employee morale through effective compensation and empowerment. A motivated and happy employee tends to be more productive.
2. Technological Risk
Technological risk includes unforeseen changes in the manufacturing, delivery, or distribution of a company's product or service.
For example, a technological risk that a business may face includes outdated operating systems that decrease production ability or disruptions in supplies or inventory. Also, a technological risk could include not investing in an IT staff to support the company systems. Server and software problems that lead to equipment downtime can increase the risk of production shortfalls and financial costs due to less revenue and idle workers.
Research and development is often a component of reducing internal risks because it involves keeping current with new technologies. By investing in long-term assets, such as technology, companies can reduce the risk of falling behind the competition and losing market share.
3. Physical Risk
Physical risk is the loss of or damage to the assets of a company. A company can reduce internal risks by hedging the exposure to these three risk types.
For example, companies can obtain credit insurance for their accounts receivable through commercial insurers, providing protection against customers not paying their bills. Credit insurance is usually very comprehensive and provides protection against debt default for a wide range of reasons, covering virtually every conceivable commercial or political reason for non-payment.
External Risk Factors
External risks often include economic events that arise from outside the corporate structure. External events that lead to external risk cannot be controlled by a company or cannot be forecasted with a high level of reliability. Therefore, it is hard to reduce the associated risks.
The three types of external risks include economic factors, natural factors, and political factors.
1. Economic Risk
Economic risk includes changes in market conditions. As an example, an overall economic downturn could lead to a sudden, unexpected loss of revenue. If a company sells to consumers in the U.S. and consumer confidence is low due to a recession or rising unemployment, consumer spending will suffer.
Companies can respond to economic risks by cutting costs or diversifying their client base so that revenue is not solely reliant on one segment or geographic region.
Increases in interest rates by the Federal Reserve can lead to higher borrowing costs by increasing the interest expense for short-term and long-term debt. For example, if a company issues a bond—which is a debt offering—to raise funds while interest rates are rising, the company will need to pay a higher interest rate to attract investors.
Also, business credit lines issued by banks, are used by companies to tap into for working capital. However, credit lines are typically variable-rate products. As interest rates rise in the overall market, so too, do the rates rise for variable-rate credit products. Rising rates also increase the cost of business credit cards.
2. Natural Risk
Natural risk factors include natural disasters that affect normal business operations. An earthquake, for example, may affect the ability of a retail business to remain open for a number of days or weeks, leading to a sharp decline in overall sales for the month. It could also cause damage to the building and merchandise being sold. Companies often have insurance to help cover some of the financial losses as a result of natural disasters. However, the insurance funds might not be enough to cover the loss of revenue due to being shut down or at a reduced capacity.
3. Political Risk
Political risk is comprised of changes in the political environment or governmental policy that relate to financial affairs. Changes in import and export laws, tariffs, taxes, and other regulations all may affect a business negatively.
Since external risks cannot be foreseen with accuracy, it is difficult for a company to reduce these three risk factors. Some types of credit insurance can protect a company against political events in other countries, such as war, strikes, confiscation, trade embargoes, and changes in import-export regulations.
Managing Business Risk
The best way to manage business risk is to maintain an adequate level of capital. A company with adequate financial resources can more effectively weather internal storms, such as updating or replacing replace faulty machinery or systems. Also, companies with proper funding can ride out unforeseen risks, such as a recession or political problems. For example, companies can carry credit insurance, which usually costs one-half of 1% of each dollar in sales revenue held on the accounts receivable ledger.
Also, having access to the credit markets and establishing financing in the form of loans, credit lines, or bonds before the risks materialize can help companies stay financially solvent during tough times. Companies with higher levels of business risk should choose a capital structure that has a lower debt ratio to help ensure it can meet its financial obligations at all times.