Business Risk Definition
Business risk is the risk associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.
Business risk can be influenced by multi-faceted factors. For example, if a firm isn’t able to produce the units to make profits, then there is a considerable business risk. Even if the fixed expenses are usually given before, there are costs that a business can’t avoid – e.g., electricity charges, rent, overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc., labor charges, etc.
Types of business risk
Since business risk can happen in multi-faceted ways, there are many types of business risks. Let’s have a look at them one by one –
#1 – Strategic risk:
This is the first type of business risk. The strategy is a significant part of every business. And if the top management isn’t able to decide the right strategy, there’s always a chance to fall back. For example, when a company introduces a new product to the market, the existing customers of the previous product may not accept it. The top management needs to understand that this is an issue of wrong targeting. The business needs to know which customer segment to aim at before it introduces new products. If a new product doesn’t sell well, there’s always a more significant business risk of running out of business.
#2 – Operational risk:
Operational risk is the second necessary type of business risk. But it has nothing to do with external circumstances; instead, it’s all about internal failures. For example, if a business process fails or machinery stops working, the business won’t be able to produce any goods/products. As a result, the business won’t be able to sell the products and make money. While strategic risk is pretty challenging to solve, operational riskOperational RiskOperational risk is the business uncertainty a company comes across in the industry while executing its everyday business operations. Such risks arise due to internal system breakdown, technical issues, external factors, managerial problems, human errors or information gap. can be solved by replacing the machinery or by providing the right resources to start off the business process.
#3 – Reputational risk:
This is also a critical type of business risk. If a company loses its goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price. in the market, there is a considerable chance that it would lose its customer base as well. For example, if a car company is blamed for launching cars without proper safety features, it would be a reputational risk for the company. The best option, in that case, is to take back all the cars and return each one after installing the safety features. The more accepting the company would be, in this case, the more it would be able to save its reputation.
#4 – Compliance risk:
This is another type of business risk. To be able to run a business, a business needs to follow certain guidelines or legislation. If a business is unable to follow such norms or regulations, it is difficult for a business to exist for long. It’s best to check the legal and environmental practices first before forming a business entity. Otherwise, later on, the business will face unprecedented challenges and unnecessary law-suits.
How to measure business risk?
Business risk can be measured by using ratios that fit the situation a business is in. For example, we can see the contribution marginContribution MarginThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution. to find out how much sales we need to increase to be able to increase the profit.
You can also use operating leverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront. ratio and degree of operating leverage to help find out the business risk of the company.
But it differs as per the situation, and not all situations will suit similar ratios. For example, if we want to know the strategic risk, we need to look at the demand vs. supply ratio of a new product. If the demand is much lesser than supply, there’s something wrong with the strategy and vice versa.
How to reduce business risk?
- First, the business should reduce costs as much as possible. There are costs that are unnecessary for businesses. For example, instead of hiring full-time employees if they hire employees on a contract, a considerable cost would be reduced. Another example of cost reduction might be using the shift formula. If the business works 24*7, and the employees work on shifts, the production every month would be huge, but the cost of rent would be similar.
- Second, the business should construct its capital structure in such a way that it doesn’t need to pay a hefty sum of money every month to pay off the debt. If a business assumes that its business risk is going through the roof, it should be trying to create a capital structure through equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule. only.
This article has been a guide to what is Business Risk. Here we discuss the four types of business risk, measurement of business risk, and how to reduce the same. You may also learn more about Corporate Finance from the following recommended articles –