What is Business Risk
Business risk is the possibility a company will have lower than anticipated profits or experience a loss rather than taking a profit. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, the overall economic climate and government regulations. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure it can meet its financial obligations at all times.
BREAKING DOWN Business Risk
Business risk impairs a company's ability to provide its investors and stakeholders with adequate returns. The company is also exposed to financial risk, liquidity risk, systematic risk, exchange-rate risk and country-specific risk. This makes it increasingly important to minimize business risk. To calculate the risk, analysts use four simple ratios: contribution margin, operation leverage effect, financial leverage effect, and total leverage effect. For more complex calculations, analysts can incorporate statistical methods.
Specific Types of Business Risk
Business risk usually occurs in one of four ways: strategic risk, compliance risk, operational risk and reputational risk.
Strategic risk arises when the implementation of a business does not go according to the business model or plan. A company's strategy becomes less effective over time, and it struggles to reach its defined goals. If, for example, WalMart Inc. strategically positions itself as a low-cost provider and Target decides to undercut WalMart's prices, this becomes strategic risk.
The second form of business risk is compliance risk. This type of risk arises in industries and sectors highly regulated with laws. The wine industry, for example, must adhere to the three-tier system of distribution, where it is a requirement for a wholesaler to sell wine to a retailer, who in turn sells it to the end consumer. Wineries cannot sell directly to retail stores. However, there are 17 states that do not have this type of distribution system, and compliance risk arises when a brand fails to understand the individual requirements and becomes noncompliant with state-specific distribution laws.
The third type of business risk is operational risk. This risk arises when the day-to-day operations of a company fail to perform. HSBC, for example, faced operational risk and a heavy fine when its internal anti-money laundering operations team was unable to adequately stop money laundering in Mexico.
Any time a company's reputation is ruined, either by one of the previous business risks or by something else, it runs the risk of losing customers based on a lack of brand loyalty. Using HSBC as a second example, the company faced high risk of losing its reputation when the $1.9 billion fine was levied for poor anti-money laundering practices.