A:

Business risk hinders a company's ability to provide its investors and stakeholders with expected returns. A company can reduce negative exposure to business risk by identifying internal risks and 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 can include:

  • union strikes
  • dishonesty by employees
  • ineffective management or leadership
  • failure on the part of external producers or suppliers

Personnel issues may pose operational challenges. Staff who become ill or injured, and as a result, are unable to work can decrease production. A company may need to hire or replace personnel key to the company's success. Strikes can force a business to close.

2. Technological risk includes unforeseen changes in 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. Having adequate capital allows a business to update or replace faulty machinery or systems.

3. 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.

External Risk Factors

External risks come up due to economic events that arise from outside of a company's organization. External events that lead to external risk cannot be controlled by any one 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 includes changes in market conditions.

As an example, facing an overall economic downturn could lead to a sudden, unexpected loss of revenue.

2. Natural risk factors include natural disasters that affect normal business operations.

An earthquake 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.

3. Political risk is comprised of changes in the political environment.

Increases in interest rates, changes in import/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.

How to Manage Business Risk

The best way to manage business risk is to maintain an adequate level of capital. Doing so allows a company to weather internal storms, to adjust or ride out unforeseen risks, and to deal with political problems.

A company with a higher level 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.

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