Updated July 21, 2023
Definition of Business Risk
Business risk can be defined as the company experiencing less than expected profit or making a loss during a particular period instead of earning a profit, and this can be driven by several factors like sales revenue, the volume of sales made, the price per unit, raw material cost, competition factor, and macro-economic factors.
What is Business Risk?
Business risk is when a business is anticipating a certain amount of profit. Instead, it cannot earn to that extent or, in severe cases, makes a loss instead of a profit. It can be defined as the exposure of a business to several factors, like sales revenue, the volume of sales made, the price per unit, raw material cost, competition factor, and macroeconomic factors, which can lower the profit or ultimately lead the business to loss. Factors that disrupt the company’s ability to perform or achieve its goals can also be defined as business risks.
These risks can come from multiple points, and we cannot hold the manager or senior management accountable. These risks may come from within the organization or even outside the firm, i.e., from certain factors related to the business or from macroeconomic factors like regulation or government decisions. Thus a risk management strategy can be a buffer to cushion the business against these types of risks to a certain extent.
Characteristics of Business Risk
The characteristics are as follows:
- Time: In older times, business risks were less, but in modern times, with the increasing competition and advent of technology, business risks have increased.
- Size of Business: Small businesses experience low risk because they are flexible in operations and highly adaptable, whereas the same is not true for big business firms.
- Nature of Business: In the case of a business that is in the manufacture or market of necessary products, business risk is low because demand is also high, whereas, in the case of business in the field of luxury goods, risks are high.
- Competition: Businesses operating in a highly competitive market are exposed to more risk than those operating in relatively less competition.
- Management Competency: The more experienced and competent management lower the chances of the business making a loss.
- Age of Business: Older businesses are less exposed to business risk as they have a set customer base and experience in handling such risks.
Types of Business Risk
The different types are as follows:
- Natural Types: Risk faced by the business on the grounds of natural calamities like floods, earthquakes, etc. These are uncontrollable and cannot be forecasted earlier too.
- Political Types: These risks generate from the political scenario prevalent in the country and decisions of political parties, which may bring about price regulations lowering the profit margin, high tax rates eating a lot of profit, and strict rules on day-to-day business.
- Social Types: These risks are generally driven by customer behavior or common social practice. Common examples of such types are changes in fashion, change in the preference of customers, change in income, and change in the consumption of customers.
- Economic Types: Risks brought in by economic factors like inflation, economic recession impacting the demand-supply chain, and a higher interest rate eating away profit.
- Managerial Types: The management’s decisions drive risks that may not be favorable to the business.
- Competitive Types: Risks are drive-by fierce competition in the market due to the entry of many players, which may threaten the survival of others.
- Technological Types: Risks driven by the advent of the latest technology or ever-changing technology that may substitute the product or the manufacturing process with the latest one or methods.
Example
A practical example of the same can be the case of the Sony Walkman, where a very popular and widely used audio device was substituted by newer products and consumer behavior, and the so-called Walkman was stopped. In this case, the risks that Sony faced were technology-driven business risks and socially-driven business risks. On the grounds of technology, Apple and other companies came with more handy devices like I-pod and Sony Walkman but stood nowhere near to it regarding features and ease of use. Based on social-driven business risk, the customers were more driven by the trend of using a smaller and latest device like the I-pod instead of a Walkman. Thus the entire business model of Sony Walkman ended in making a loss, and finally had to shut down the business.
Factors Affecting Business Risk
The several factors affecting the same are as follows:
- Preference of Customers: Consumer preference plays a major role in the business as it is ultimately the customer who is the king, and the taste and choice of customers drive the market.
- Demand and Volumes of Sales: The demand-supply chain prevailing in the market and, thus, the sales volume will impact the profit-making of every business.
- Per Unit Price and Raw Material Cost: The profitability of every company depends on the cost of raw materials and, finally, per unit price of the product, which decides based on the potentiality of sales and how much profit/loss it can make.
- Competition: Businesses operating in a highly competitive market face more risk than those operating in relatively less competition because competition plays a major role.
- Economic Scenario: Risks brought in by economic factors like inflation, economic recession impacting the demand-supply chain, and a higher rate of interest eating away profit.
- Government Regulations: Regulations brought in by the government can eat away a lot of profit and also bring a barrier to the ease of doing business.
How to Manage Business Risks?
A few techniques to manage or avoid the risk are as follows:
- Risk Management Strategy: Nowadays, businesses establish separate teams to study or manage risks, thereby implementing methods to minimize, if not avoid, the risks.
- Identify Risk: A sound business plan can identify or analyze the threat to the business at the very start rather than not waiting for something to happen. This requires a more proactive behavior of the management.
- Recording of Risk: The moment the management is done with a plan to deal with the risk, it is essential to record it so that in the future, if any same situation arises, the management can easily deal with it then as risks are not static and can repeat during the business cycle.
Difference Between Business Risk vs Financial Risk
Business risk means not making the firm profitable, whereas financial risk means not paying off the debt or meeting the firm’s financial obligations. Business risk is purely operational, whereas financial risk relates to debt payment. Business risks are not controllable and thus unavoidable, whereas financial risks are controllable and avoidable. Business risks are prevalent as long as the business operates, whereas a financial risk exists until equity financing increases.
Businesses can employ systematic measures to conduct day-to-day operations and minimize costs, thus managing business risk. You can manage financial risk by reducing the debt level and increasing the equity level. EBIT (can be used to assess business risk, while financial risk can be measured by examining financial leverage numbers and the debt-asset ratio.
Advantages and Disadvantages of Business Risk
The advantages and disadvantages of the same are as follows:
Advantages
- It makes the business think outside the box and consider facts like improving operations.
- This faced by businesses makes their business more adaptable to future scenarios and changes.
- This faced by businesses makes a firm work more effectively and efficiently, minimizing the cost of operations.
- It prepares the business for the current consumer trend and adheres to the statement that the customer is king.
Disadvantages
- At times to manage the risk, the company may incur more losses and costs of expenditure.
- Managing the risk involves many costs in the form of changes in technology, assets, or teams.
- Higher salaried costs in raising a team to study and manage the risk.
- This may impact the entire business, leading to the firm’s shutdown.
- Business impacts the profitability of the firm.
Conclusion
Business risk is a common factor every business faces with changing times, consumer behavior, and technology. The management can systematically manage it to some extent if they proactively prevent the company’s profitability from going down. It has also given the scope of employment these days as companies prefer to hire people with expertise in studying and managing risk.
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