Business Risk

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 achieve its financial goals is considered a business risk. There are many factors that can converge to create business risk. Sometimes it is a company's top leadership or management that creates situations where a business may be exposed to a greater degree of risk.

However, sometimes the cause of risk is external to a company. Because of this, it is impossible for a company to completely shelter itself from risk. However, there are ways to mitigate the overall risks associated with operating a business; most companies accomplish this through adopting a risk management strategy.

Understanding Business Risk

When a company experiences a high degree of business risk, it may impair its ability to provide investors and stakeholders with adequate returns. For example, the CEO of a company may make certain decisions that affect its profits, or the CEO may not accurately 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:

A company with a higher amount of business risk may decide to adopt a capital structure with a lower debt ratio to ensure that it can meet its financial obligations at all times. With a low debt ratio, when revenues drop the company may not be able to service its debt (and this may lead to bankruptcy). On the other hand, when revenues increase, a company with a low debt ratio 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.

Types of Business Risk

Strategic Risk

Strategic risk arises when a business does not operate according to its business model or plan. When a company does not operate according to its business model, its strategy becomes less effective over time and it may struggle 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 for Walmart.

Compliance Risk

The second form of business risk is referred to as compliance risk. Compliance risk primarily arises in industries and sectors that are highly regulated. For example, in the wine industry, there is a three-tier system of distribution that requires wholesalers in the U.S. to sell wine to a retailer (who then sells it to consumers). This system prohibits wineries from selling their products directly to retail stores in some states.

However, there are many U.S. states that do not have this type of distribution system; compliance risk arises when a brand fails to understand the individual requirements of the state that it is operating within. In this situation, a brand risks becoming non-compliant with state-specific distribution laws.

Operational Risk

The third type of business risk is operational risk. This risk arises from within the corporation, especially when the day-to-day operations of a company fail to perform. For example, in 2012, the multinational bank HSBC faced a high degree of operational risk and as a result, incurred a large fine from the U.S. Department of Justice when its internal anti-money laundering operations team was unable to adequately stop money laundering in Mexico.

Reputational Risk

Any time a company's reputation is ruined, either by an event that was the result of a previous business risk or by a different occurrence, it runs the risk of losing customers and its brand loyalty suffering. The reputation of HSBC faltered in the aftermath of the fine it was levied for poor anti-money laundering practices.

Special Considerations

Business risk cannot be entirely avoided because it is unpredictable. However, there are many strategies that businesses employ to cut back the impact of all types of business risk, including strategic, compliance, operational, and reputational risk.

The first step that brands typically take is to identify all sources of risk in their business plan. These aren't just external risks — they may also come from within the business itself. 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 any identifiable risks before they become too great.

Once the management of a company has come up with a plan to deal with the risk, it's important that they take the extra step of documenting everything in case the same situation arises again. After all, business risk isn't static — it tends to repeat itself during the business cycle.

Finally, most companies adopt a risk management strategy. This can be done either before the business begins operations or after it experiences a setback. Ideally, a risk management strategy will help the company be 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.