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 plough back some profits.
For example, suppose operating incomes are expected to be 10% in a year, business risk would be low when operating income varies between 9 and 11%. If the operating income is as low as 5% or as high as 16%, then the business risk is high.
5 Types of Business Risks
Modern business is exposed to several risks. Goods are produced in anticipation of a demand. The demand itself is contingent in most cases. Besides, there is a time gap between production and distribution. The businessman has to face several risks before distribution of the product. Some of the risks are described below.
1. Price Change
In a free market, fluctuations in prices are common. Such fluctuations are sometimes very violent and result in a loss to the businessman. It is very difficult to secure full coverage against adverse price changes. Hence, these risks cannot be avoided by insuring.
2. Credit Risks
Credit is the lifeblood of every business firm. Sales on credit terms are almost universal and no businessman can avoid credit sales. But at the same time, there are also chances for credit risks. The debtors may fail to repay the debt. Credit risk can be insured. But in our country credit risk cannot be insured. However the businessman can avoid such risks by creating adequate reserve for bad and doubtful debts. This device in fact is a kind of self-insurance.
3. Supply Risks
Profits are not certain when the production schedule is not certain. The entrepreneur cannot go ahead with his production schedule when the supply is irregular. This type of risk cannot be avoided altogether. In fact, this risk cannot be insured.
4. Change in Quality
Risk of loss due to deterioration inequality of goods is considerable for perishable goods like fruits and vegetables. Goods can also be damaged in transit and thereby deteriorate in quality. Seawater is corrosive and it affects the quality of the goods adversely. The risks arising due to these reasons can be insured and the resultant loss can be avoided.
5. Demand Risk
Buying motives and habits are dynamic. Fashions and tastes are always changing. Consequently the demand may also change. The changes in demand will adversely affect the businessman. Particularly, when the product has an elastic demand the businessman cannot escape from this risk unless he is cautious and have a thorough knowledge of the market. This sort of risk cannot be avoided by insuring with an insurer. Normally, insurance companies will not also undertake to cover the demand risk.
Beside the risks cited above, there are also other risks to which businessmen are exposed. These risks include reduction in the volume of sales due to substitute sales, Government interference, contract defaults, employee misbehavior like strikes, lockout, and public misbehavior like civil war, riots etc.
All the risks cannot be avoided by means of insurance. Insurance companies all over the world; generally undertake to cover only very few kinds of risks such as fire, accidents etc. Innovations are also being introduced in insurance business. For instance, crop insurance is a novel form of insurance becoming popular in all the countries.
Categories of business risks
Business risk can be divided into two broad categories, namely
- internal business risk and;
- external business risk.
1. 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 in coping with these risks.
The important internal risks include:
- Fluctuations in sales,
- Research and development,
- Personnel Management,
- Fixed Cost; and
- Production of single product.
1. Fluctuation in the sales
Every company strives to maintain its market share. In the competitive market, loss of customer will lead to loss of profit. So, a company should build a strong customer-base by employing appropriate channels of distribution and a dedicated sales force to help build a strong customer base.
2. Research and development
In the modern business world, some products become obsolete due to abrupt changes in tastes and preferences or technology. To overcome the problem of obsolescence, a company has to concentrate on in-house research and development. Research should be undertaken constantly to introduce new products replacing the old ones. Expenditure incurred on research and development will help promote the operational efficiency of the firm in the long run.
3. Personnel Management
The operational efficiency of the firm ultimately depends upon the management of personnel of the company. Frequent strikes and lock outs would affect the rate of production. Consequently, the labour productivity which is key to the operational efficiency, would suffer. By offering attractive compensation plans, a highly motivated labour force can be formed. This would boost
- the employee’s morale,
- higher productivity; and
- less wastage in the production processes.
4. Fixed Costs
Proper control over costs can minimize the risks that arise out of the cost behavior of the factors of production. A high fixed cost during recession or low demand for product is disadvantageous to the firm. The firm cannot aim at reducing the fixed cost at that stage. So, the fixed cost proportion has to be kept reasonably so as to not to affect the profitability of the firm.
5. Production of Single Product
When a firm produces a single product, the rate of internal risks will be certainly higher. The profitability of the firm solely depends upon a single product. The fall in demand for the product would reduce the profitability. On the other hand, if the firm has a number of product items, a fall in the demand for one product may be compensated by the rise in demand for other products.
2. 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.
1. Business Cycle
The most important external factor is probably the business cycle. The fluctuations of the business cycle would lead to fluctuations in the earnings of the firm. During recession, the demand for products falls greatly. So, most of the firms may even be forced to close their business. On the other hand, during the boom period, there would be a great demand for the products. Some industrial concerns move automatically with the business cycle while others move counter cyclically.
A successful firm is one which is able to move counter cyclically during the recessionary period. The effects of the business cycle vary from one company to another. In some cases, the recession may lead to fall in the profit and growth rate of the firm, whereas in other cases the firms with inadequate customer base are forced to close down their business.
2. Demographic Factors
External business risks arise out of demographic factors such as geographical distribution of population by age group and race. Demographic factors influence to a great degree the working of business units. The success of business operations depends on the health, education and skills of the employees besides their attitude towards work. Poor productivity in business units is due to poor health, education and lack of skill of their employees. A country which is endowed with educated and good citizens produces excellent entrepreneurs and successful business units.
3. Government Policies
Risks also arise due to changes in the government policies. Every government pursues its own policy. In India, whenever there has been a change of government, we have witnessed significant changes in the overall policies affecting the business.
For example, Liberalization policy was introduced when Shri. Manmohan Singh was the finance minister in early 1990s. Subsequently, during the rule of Bharathiya Janatha party, there was pressure on the government to give importance to Swadeshi industries. So, any changes in policies towards nationalization, disinvestment, foreign direct investment and the role of multi-national companies, etc., significantly affect the cost and availability of funds for investment in securities.
4. Social and regulatory factors
The profitability of the industry is affected by regulatory forces over the general operating environment. Environmental Protection Act, price control, fixation of quotas, import and export control, policies with regard to monetary and fiscal matters can affect the revenues of the firms.
Generally, risk is more prevalent in industries related to public utility services such as banking, insurance, telecommunication, transport, etc. The government’s tariff policy has a direct bearing on the earnings of the telecom sector. Similarly, the RBI’s directives with regard to interest rates, lending policies, etc., affect the profitability of the banking sector.
For example, the directives issued by the Pollution Control Board over the treatment of effluent in leather industry has affected the prosperity of leather industry.
- Meaning of Business Risk
- 5 Types of Business Risks
- Categories of business risks