What Is Business Risk?
Business risk is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail.
Anything that threatens a company's ability to meet its target or achieve its financial goals is called business risk. These risks come from a variety of sources, so it's not always the company head or a manager who's to blame. Instead, the risks may come from other sources within the firm or they may be external—from regulations to the overall economy.
While a company may not be able to shelter itself from risk completely, there are ways it can help protect itself from the effects of business risk, primarily by adopting a risk management strategy.
Understanding Business Risk
Business risk is associated with the overall operation of a business entity. These are things that impair its ability to provide investors and stakeholders with adequate returns. For example, a business manager may make certain decisions that affect its profits or he may not anticipate certain events in the future, causing the business to incur losses or fail.
Business risk is influenced by a number of different factors including:
- Consumer preferences, demand, and sales volumes
- Per-unit price and input costs
- The overall economic climate
- Government regulations
The company is also exposed to financial risk, liquidity risk, systematic risk, exchange-rate risk, and country-specific risk. These make it increasingly important to minimize business risk.
A company with a higher amount of business risk should choose a capital structure with a lower debt ratio to ensure it can meet its financial obligations at all times. When revenues drop, the company may not be able to service its debt, which may lead to bankruptcy. On the other hand, when revenues increase, it experiences larger profits and is able to keep up with its obligations.
To calculate 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. Business risk usually occurs in one of four ways: strategic risk, compliance risk, operational risk, and reputational risk.
Specific Types of Business Risk
Strategic risk arises when a business does not operate 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 strategically positions itself as a low-cost provider and Target decides to undercut Walmart's prices, this becomes a strategic risk.
The second form is compliance risk. This arises in industries and sectors which are highly regulated with laws. The wine industry, for example, must adhere to the three-tier system of distribution, where a wholesaler is required to sell wine to a retailer, who in turn sells it to consumers. Wineries cannot sell directly to retail stores.
However, 17 states do not have this type of distribution system, and compliance risk arises when a brand fails to understand the individual requirements, thus becoming noncompliant with state-specific distribution laws.
The third type of business risk is operational risk. This risk arises from within the corporation—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. Going back to HSBC, the company faced the high risk of losing its reputation when the $1.9 billion fine was levied for poor anti-money laundering practices.
[Important: There are still other risks that can occur infrequently such as natural disasters and weather-related issues for which companies still need to account.]
- Business risk is any exposure a company or organization has to factor(s) that will lower its profits or lead it to fail.
- Business risk comes from different sources including consumer taste and demand, the overall economy, and government regulation.
- While businesses may not be able to completely avoid risk, they can take steps to mitigate the impact including the development of a strategic risk plan.
How to Avoid Business Risk
While business risk cannot be avoided as a whole—because they can often be unpredictable— there may be ways in which to cut back the impact:
Identify risks. Part of any business plan should be to identify an analyze any potential threats to the business. These aren't just external risks—they may also come from within the business itself.
Don't wait. Taking action to cut back the risks as soon as they present themselves is key. Management should come up with a plan in order to deal with it head-on before it blows up.
Record the risks. Once management has come up with a plan to deal with the risk, it's important to document everything just in case the same situation arises again. After all, risk isn't static—it tends to repeat itself during the business cycle.
Risk management strategy. This is an important factor in any business. Coming up with a strategy—whether it's done before the business begins operations or after it experiences a setback—will help guide the firm through any ups and downs, making the company better prepared to deal with risks as they present themselves. The plan should have tested ideas and procedures in place in the event that risk presents itself.