What does Business Risk mean? Business risks related to the response of the firm’s earnings before interest and taxes, or operating profits, to changes in sales. When the cost of capital is used to evaluate investment alternatives, it is assumed that acceptance of the proposed projects will not affect the firm’s business risk.
Know and understand the Explanation of Business Risk.
The business risk may be defined in terms of the possibility of occurrence of un-favorable events; which maximize chances of losses and minimize chances for gain, in business. The term business risk refers to the possibility of inadequate profits or even losses due to uncertainties e.g., changes in tastes, preferences of consumers, strikes, increased competition, change in government policy, obsolescence etc.
Every business organization contains various risk elements while doing the business. Business risks imply uncertainty in profits or danger of loss and the events that could pose a risk due to some unforeseen events in the future, which causes the business to fail. The types of projects accepted by a firm can greatly affect its business risk.
If a firm accepts a project that is considerably more risky than average, suppliers of funds to the firm are quite likely to raise the cost of funds. This is because of the decreased probability of the fund suppliers receiving the expected returns on their money. A long-term lender will charge higher interest on loans if the probability of receiving periodic interest from the firm and ultimately regaining the principal is decreased.
Common stockholders will require the firm to increase earnings as compensation for increases in the uncertainty of receiving dividend payments or ably appreciation in the value of their stock. In analyzing the cost of capital it is assumed that the business risk of the firm remains unchanged (i.e., that the projects accepted do not affect the variability of the firm’s sales revenues).
This assumption eliminates the need to consider changes in the cost of specific sources of financing resulting from changes in business risk. The definition of the cost of capital developed in this chapter is valid only for projects that do not change the firm’s business risk.
Meaning of Business Risk:
Business risk is that portion of the unsystematic risk caused by the prevailing environment of the business. In other words, business risk is a function of operating conditions being faced by a firm. These risks influence the operating income of a firm and consequently the dividends.
Every company has its own objectives and goals and aims at a particular gross profit and operating income. It expects itself to pay to its shareholders a certain rate of dividend and plow back some profits.
For example, an owner of a business may face different risks like in production, risks due to irregular supply of raw materials, machinery breakdown, labor unrest, etc. In marketing, risks may arise due to different market price fluctuations, changing trends and fashions, error in sales forecasting, etc. In addition, there may be the loss of assets of the firm due to fire, flood, earthquakes, riots or war and political unrest which may cause unwanted interruptions in the business operations. Thus business-risks may take place in different forms depending upon the nature and size of the business.
Definition of Business Risk:
Definition: By the term “Business risk” we mean the uncertainty with respect to the firm’s operations. It is a type of systematic risk wherein there is volatility associated with the future income or earnings arising from events, circumstances, conditions, action, or inactions that hinders the attainment of goals and objectives and carry out the strategies.
Business risk refers to the anticipation that the firm may earn lower than expected profits or even suffer losses, because of the uncertainties inherent in the business such as competition, change in customer tastes and preferences, input cost, change in government policies, and so forth. It may impede the business ability to provide returns on the investment.
Following are cited some popular definition of the term business risk:
According to B.O.Wheeler,
“Risk is the chance of loss. It is the possibility of some un-favorable occurrence.”
According to C.O. Hardy,
“Risk may be defined as uncertainty in regard to cost, loss, or damage.”
Characteristics of Business Risk:
Characteristics of business-risks could be highlighted with reference to its following features:
In ancient times, business-risks were less and limited. In the present-day-times-characterized by intense competition, advanced technology and globalization of the economy; business-risks are quite severe. Further, in times to come, business-risks are likely to increase in intensity.
The Size of Business Enterprise.
Small businesses are less exposed to business-risks; because they enjoy the flexibility of operations and can easily adapt themselves to changing circumstances. On the other hand, the bigger is the size of business; the lesser is the flexibility possessed by it. Hence bigger businesses are more exposed to business risks.
Nature of Business Risks.
In case of business enterprises engaged in the manufacture/purchase of necessary items e.g. salt, sugar, oil, cloth etc. there is the lesser risk because demand for most of the necessary item is inelastic or less elastic. On the other hand, business enterprises engaged in the manufacture/purchase of luxury items are more exposed to business-risks; because demand for luxury items is highly elastic.
Terms of Sales.
In the case of business enterprises conducting sales only on a cash basis, business-risks are nil; so far as the possibility of bad debts is concerned. On the other hand, business enterprises conducting large scale credit sales are severely exposed to the risk of bad debts.
The Degree of Competition.
In those lines of business activities, where there is intense competition; business enterprises are exposed to severe risks caused by the actions and reactions of competitors. As such, business enterprises characterized by monopolistic situations face little risk on account of competition. Actually, in a perfectly monopolistic situation, the business enterprise has no risk caused by competition.
The Competence of Management.
The more competent the management of business enterprises is; the lesser is the possibility of losses to be caused as a result of business risks, and vice-versa.
The Age of the Business Enterprise.
From this viewpoint, old business enterprises are less exposed to business-risks, because of the experience of successfully handling business-risks, in the past. New business concerns are more exposed to business-risks, because of the lack of experience.
Opportunities for Gains are Hidden in Business Risks.
If the management of the business enterprise is able to successfully handle and manage business-risks; these provide many opportunities for gains to the business enterprise.
Sources of Business Risk:
Business risk can be divided into two broad Sources, namely;
- Internal business risk, and.
- External business risk.
Internal Business risks.
Internal business risk is associated with the internal environment of the firm. The internal business-risks are such that the firm has to conduct its business within its limiting environment. The internal business-risks will vary from firm to firm depending upon the constraints in the internal environment. Thus, each firm has its own set of internal risks and the firm’s success depends upon the ability to coping with these risks.
The important internal risks include:
- Fluctuations in sales.
- Research and development.
- Personnel Management.
- Fixed Cost, and.
- Production of a single product.
The risks that emerge as a result of the events occurring within the organization is termed as an internal risk. These risks can be predicted as the possibility of their incidence, and so, they are controllable in nature. They arise due to factors like strikes & lockouts by a trade union, accidents in the factory, negligence of workers, failure of the machine, technological obsolescence, damages to the goods, fire outbreak, etc.
External Business risks.
External business-risks are associated with circumstances beyond a firm’s control. Each firm has to deal with specific external factors that may be unique and peculiar to its industry.
However, important external factors influencing all businesses are:
- Business cycle.
- Demographic factors.
- Government policies, and.
- Social and regulatory factors.
The risk arising as a result of the events external to the firm and so the firm’s management has no control over it. So, these cannot be forecasted easily. It may arise due to price fluctuations, changes in customer taste, earthquake, floods, changes in government regulations, riots, etc.
Types of Business Risks:
Some risks are common to all human being alike everywhere e.g. risks due to fire, theft, flood, earthquakes, cyclones, drought, war, civil riots etc. As such these are not the risks peculiar only to business. Moreover, some risks are insurable with insurance companies.
Hence, as such, in the present- day-times offering many types and varieties of insurances; these risks could not be termed as risks in the real sense of the term. Accordingly, business-risks are those which are peculiar only to business and are also not- insurable.
Following is a brief account of the above types of business-risks:
Risks which arise due to the actions of Nature (and hence uncontrollable) are called natural risks. For example, the risk of rainfall not occurring on time or excessive rainfall causing flood is a serious risk for farmers. Again, there may be the risk of hail storm destroying crops in the field.
Risks due to political causes may arise, in the forms of:
- Price regulations, restricting profit margins for businessmen.
- High rates of taxes, taking away a major part of business profits.
- Un-favorable economic policies, discouraging some lines of business activities, and.
- Strict legislation imposed on business enterprises etc.
Risks due to social causes are those which may arise from consumer behavior or due to changes taking place in the social scene.
Examples of social risks may be:
- Changes in fashions.
- Change in the tastes or preference of consumers.
- Changes in the income of consumers, and.
- Changing social values leading to a new pattern of social life etc.
Some of the economic types leading to business-risks may be:
- The rising cost of raw materials due to inflation or crop failure.
- The economic recession in industry, leading to poor demand.
- Increase in the rate of interest, making borrowings costlier, and.
- Pessimistic capital market conditions, discouraging people to invest in companies etc.
Risks due to managerial types may be (a few examples only):
- Wrong estimation of demand by management.
- Poor labor-management relations, and.
- The inefficient operational life of the business enterprise due to incompetent or untrained managerial staff.
Competitive Types may cause business-risks e.g. in the form of the following:
- Entry of an unduly large number of persons in the same line of business activity, and.
- Entry of multinational companies threatening the very survival of domestic companies.
In the present-day times, technology is changing at a very fast pace; so much so that business experts call this phase of changes as a “technological revolution”. The appearance of new technology renders the old technology as obsolete (i.e. out of use); causing severe financial losses to firms operating with old technology. They are virtually compelled to install new technology to ensure their survival amidst intensely competitive conditions.
Some miscellaneous types of business-risks may be:
- Insolvency of a customer.
- Worker’s strike.
- Sudden power failure.
- The premature death of an expert employee or manager, and.
- Speculative losses.