Business Risk – Types & How to Mitigate Risk.

Denise Elizabeth P
Senior Financial Editor & Contributor
Last Updated: August 30, 2021
Date Published: August 30, 2021

It is known that every business comes with its own risks but what exactly are business risk?

Also, what are the types of business risks out there? And, how do we plan or prepare for these risks?

To answer these questions, below we will be discussing what a business risk is, how to identify these kinds of risks and how to mitigate them.

Defining a Business Risk

business risk

As a business operates, it will be exposed to several kinds of scenarios, circumstances and situations that could possibly affect the financial performance of a company and that is where the business risk comes in.

To elaborate further, anything that will hinder the company from increasing its earnings and achieving the financial goals it has set is considered as a business risk.

A business risk could be the result of a number of different factors like how the reality of an outcome – no matter how well planned or thought out it was – could end up being something completely unexpected or unaccounted for.

A business risk could also be a result of the decisions a company’s top leaders or managers make which would ultimately affect the way a company can progress as it goes forward.

There are cases when a business risk can be avoided however, it is also possible for business risks to go beyond what a company can control.

It is impossible to completely eliminate every single business risk a company would have to face.

Hence, there are several existing methods that help firms reduce the risks they are likely to be subjected to especially when it comes to the ones that affect their business’ operations.

The implementation of a risk management strategy is the best practice that helps protect businesses from the effects of the risks they may encounter.

Key points to consider:

  1. A business risk is any situation that can adversely affect the financial performance of a company, firm, or organization.
  2. There are different sources of business risks and they can span from the rules and regulations mandated by the government, the financial performance of a company, and the changes regarding the needs and wants of a consumer base.
  3. Though companies cannot fully evade every business risk, there are methods available that could alleviate the effects of these kinds of risks on the business. One of these methods is the establishment of a strategic risk system.

Understanding the Business Risk

Stakeholders are individuals who have supported the business from the day it was conceptualized.

Without the support of these stakeholders, the business would have probably never existed.

Supplying the stakeholders, as well as the investors, with just and satisfactory returns is an obligation that companies have to fulfill though the fulfillment of this obligation can be impaired when the business is exposed to a high degree of risks.

For instance, the choices made by the CEO would probably affect the financial performance of a company as a whole such as what happens when a decision made has cost the company a significant number of losses.

When the losses are too large, it would not be possible for stakeholders or investors to gain additional returns from the losses that were incurred and when worse comes to worst, losses that are too large to recover from can result in the company shutting down or filing for bankruptcy.

Again, there are different causes of business risks. Some of these are the following:

  • The desire of a consumer to buy goods and services based on the price (consumer demand), the taste of a consumer regarding the benefits of a product (consumer preferences), and the quantity of units sold (sales volume).
  • The unit price of a product and the costs incurred to make a product.
  • The competition within a market.
  • The state of the economy as a whole.
  • The rules and regulations mandated by the government.

For a company to thoroughly fulfill its financial obligations, businesses would opt to establish and implement a financial composition that ideally has a low debt ratio.

A low debt ratio is preferable to firms whose risks are high in numbers.

When profits increase and a company has already established a low debt ratio, businesses can fulfill their debts and incur substantial earnings.

However, companies with a high debt ratio would find it difficult to keep up with their liabilities and therefore result in bankruptcy if these liabilities continue to be improperly managed.

An expert would calculate a business risk using four basic formulas:

  1. Contribution Margin Ratio – a ratio that shows the money available to cover fixed expenses after deducting variable costs.
  2. Operating Leverage Effect Ratio – a ratio that indicates the breakeven point of a company or how much of the sales is used to cover both fixed and variable costs.
  3. Financial Leverage Effect Ratio – a ratio that measures how much of the liabilities are used for business operations.
  4. Total Leverage Effect Ratio – a ratio that combines both the operating leverage effect ratio and the financial leverage effect ratio. This ratio assesses the effects of both ratios previously mentioned on a company’s earnings per share.

Experts can include statistical computations for a more thorough evaluation. A business risk typically happens no matter the kind of industry a business operates in.

Identifying a Business Risk

types of business risk

Preparing for a business risk mostly starts in being able to identify the risks to begin with.

Below are the four kinds of business risks a company will usually face:

Strategic Risk

A business has to adopt strategies and plans in line with the company’s business model to continue operating effectively.

When companies fail to do so, the strategies currently used – or the lack thereof – are not going to help the company reach its financial goals or plans and this is what is known as a strategic risk.

An example of a strategic risk is when Walmart purposefully sells products at the lowest price possible and Target ends up offering the same goods and services that Walmart has but at a lower price, successfully undercutting Walmart in the process which then becomes a strategic risk for Walmart.

Compliance Risk

Highly overseen business sectors and industries may be vulnerable to compliance risks.

One of the business sectors thoroughly supervised is the wine industry or wineries.

To illustrate, the wine industry operates on a three-party distribution system: the wholesalers, the retailers, and the consumers.

The three-party system forbade wineries from operating directly with retail store owners.

Wineries should sell their products to the wholesalers, who then sell those products to retailers, and finally having the products bought by the consumers from retailed outlets.

Despite this, several wineries in the United States do not implement the three-party distribution system.

It is because of this that those certain wineries are exposed to compliance risks.

A compliance risk happens when a company does not recognize and comply with the standard operating procedure of the industry it is operating in.

Essentially, non-compliance with the state law is a compliance risk for businesses.

Operational Risk

An operational risk is an internal business risk.

An operational risk happens when companies do not perform their daily operations accordingly.

For example, sometime in 2012, a multinational bank, the Hong Kong and Shanghai Banking Corporation (HSBC), faced charges and paid fines amounting to $1.92 billion to the United Stated authority for failing to perform business operations appropriately.

HSBC’s anti-money operations team allowed money laundering in Mexico and was unable to prevent it from happening.

Reputational Risk

One of the aftermaths HSBC experienced was losing its reputation due to the failure of implementing a system for anti-money laundering.

Whenever a company’s reputation is destroyed, the company will encounter several challenges such as losing both current and potential customers along with their brand loyalty.

Mitigating Business Risk

Mitigating business risk

Business risks can often be unforeseeable therefore there will be times when these risks are unavoidable.

Despite this, companies can adopt strategies and methods to reduce the effect of all types of business risks whether it is strategic, compliance, operational, or reputational.

Recognizing all causes of risks in the business is usually the first step that companies make in devising a plan.

Companies must include both internal and external business risks when formulating an effective plan.

There is a saying that prevention is always better than cure. So, knowing how to prevent a risk from happening is an important factor to consider when devising an appropriate plan.

Constructing different strategies to prevent the risk from escalating is the responsibility of the top leaders and managers of the company.

Since business risks tend to happen repeatedly throughout the business cycle, documentation is extremely important when implementing the strategies to resolve a business risk.

After coming up with a plan to mitigate the risk, documenting the process of implementing the plan would help managers make revisions in the future when necessary.

Adopting a risk management strategy is the best course of action to take when dealing with unpredictable scenarios that can affect the business’ capacity to earn.

A risk management strategy is either implemented before beginning the business operation or after it has encountered a problem.

A useful risk management strategy has already evaluated ideas and improved techniques.

A risk management strategy will better prepare a company if the same problems happen again.

A risk management strategy is also the overall way for a company to mitigate the business risks it may face as they continue their operations.

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