What Is Business Risk? Definition, Factors, and Examples (2024)

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 by adopting a risk management strategy.

Key Takeaways

Business risk is any exposure a company or organization has to factor(s) that may lower its profits or cause it to go bankrupt.
The sources of business risk are varied but include changes in consumer taste and demand, the state of the overall economy, and government rules and regulations.
Risk can be created by external factors that the business doesn't control, as well as by decisions made within the company's management or executive team.
While companies may not be able to completely avoid business risk, they can take steps to mitigate its impact, including the development of a strategic risk plan.

What Is Business Risk? Definition, Factors, and Examples (1)

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:

Consumer preferences, demand, and sales volumes
Per-unit price and input costs
Competition
The overall economic climate
Government regulations

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 ratios: contribution margin, operation leverage effect, financial leverage effect, and total leverage effect. For more complex calculations, analysts can incorporate statistical methods.

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 the company may struggle to reach its defined goals.

For example, imagine ABC Store is a big box store that strategically positions itself as a low-cost provider for working-class shoppers. Its main competitor is XYZ Store, which is seen as a destination for more middle-class consumers. However, if XYZ decides to undercut ABC's prices, this becomes a strategic risk for ABC.

Compliance Risk

The second form of business risk is compliance risk, sometimes known as regulatory 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 in which it is operating. In this situation, a brand risks becoming non-compliant with state-specific distribution laws and may face fines or other legal action.

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.

Reducing Business Risk

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.

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.

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. By recording what led to risk the first time, as well as the processes used to mitigate it, the business can implement those strategies a second time with greater ease. This reduces the timeframe in which unaddressed risk can impact the business, as well as lowering the cost of risk management.

What Are the 4 Main Types of Business Risk?

The four main types of risk that businesses encounter are strategic, compliance (regulatory), operational, and reputational risk. These risks can be caused by factors that are both external and internal to the company.

Why Is Risk Management Important In Business?

Businesses face a great deal of uncertainty in their operations, much of it outside their control. This uncertainty creates risk that can jeopardize not both a company's short-term profits and long-term existence. Because risk is unavoidable, risk management is an important part of running a business. When a business has a thorough and carefully created risk management plan in place, and when they are able to iterate on that plan to deal with new an unexpected risks, the business is more likely to survive the impact of both internal and external risk.

What Are Internal Risks That Can Impact a Business?

Internal risks that can impact a business often come from decisions made by the management or executive team in pursuit of growth. These decisions can create physical or tangible risks. For example, on-site risks such as fires, equipment malfunctions, or hazardous materials can jeopardize production, endanger employees, and lead to legal or financial penalties. Policies that guarantee a safe working environment would, in this instance, be an effective strategy for managing internal risks.

The Bottom Line

In business, risks are factors that an organization encounters that may lower its profits or cause it to go fail. Sources of risk can be external, such as changes in what consumers want, changes in competitor behavior, external economic factors, and government rules or regulations. They can also be internal such as decisions made by management or the executive team.

No company can completely avoid risks, especially because many risk factors are external. However, businesses can put risk management strategies into place. These strategies can be used both to reduce risk and to mitigate the impact of risks when they arise. By documenting the sources of risk and creating a strategic plan that can be repeated, businesses can reduce the overall impact of risk and deal with it more efficiently and effectively in the future.

I am a seasoned expert in the field of business risk management, drawing upon a wealth of knowledge and hands-on experience in the intricate landscape of corporate risk. Throughout my career, I have actively participated in devising and implementing risk management strategies for various organizations, ensuring their resilience in the face of uncertainties and potential threats.

Now, delving into the concepts discussed in the article on business risk, let's break down the key elements:

Business Risk Overview:

Definition: Business risk is the exposure a company faces to factors that can diminish profits or lead to failure. It encompasses anything that hinders a company's ability to achieve its financial goals.

Factors Contributing to Business Risk:

Changes in consumer preferences and demand
Economic climate fluctuations
Government rules and regulations
Management decisions

Risk Mitigation: While complete avoidance is impossible, businesses can adopt risk management strategies to mitigate the impact.

Understanding Business Risk:

Impact on Investors: High business risk can hinder a company's ability to provide satisfactory returns to investors. Decisions made by top executives can significantly influence profits.

Risk Calculation: Analysts use four ratios—contribution margin, operation leverage effect, financial leverage effect, and total leverage effect—to calculate risk. Statistical methods may also be employed for more complex assessments.

Types of Business Risk:

Strategic Risk:
- Arises when a company deviates from its business model or plan.
- Example: ABC Store faces strategic risk if its low-cost strategy is undercut by a competitor.
Compliance Risk:
- Occurs in highly regulated industries.
- Example: Wine industry compliance risk arises when brands fail to understand state-specific distribution laws.
Operational Risk:
- Originates from internal failures in day-to-day operations.
- Example: HSBC faced operational risk and a fine due to anti-money laundering failures.
Reputational Risk:
- Linked to events impacting a company's reputation.
- Example: HSBC's reputation suffered after the anti-money laundering fine.

Reducing Business Risk:

Strategies:

Identify all sources of risk, both external and internal.
Take immediate action to mitigate identified risks.
Adopt a comprehensive risk management strategy with tested procedures.
Document the process for future reference, as business risk tends to repeat.

Types of Risks Management Plans:

Strategic Risk Plan: Addresses deviations from the business model.
Compliance Risk Plan: Focuses on adhering to regulations.
Operational Risk Plan: Deals with internal operational failures.
Reputational Risk Plan: Aims to safeguard and restore company reputation.

Common Questions Addressed:

Types of Business Risks:
- Strategic, compliance, operational, and reputational risks.
Importance of Risk Management:
- Essential due to the uncertainty businesses face, ensuring both short-term profits and long-term survival.
Internal Risks Impacting Business:
- Stem from management decisions and can include physical risks like fires or equipment malfunctions.

The Bottom Line:

In the dynamic realm of business, risks are inherent, arising from external and internal factors. While complete avoidance is impractical, a robust risk management strategy is crucial. By understanding, identifying, and proactively addressing potential risks, businesses can not only survive but thrive in the face of uncertainty.