Sixty percent of business organizations face a wide range of increasing risks, according to a Chartered Global Management Accountant report on the Global State of Enterprise Risk. But less than 35 percent of these companies have a formal enterprise risk management program in place. Thirty percent of U.S. companies report experiencing an operational surprise over the past five years, indicating that the odds of being confronted with a risk you’re not ready for are relatively high. To improve the odds in your favor so you can avoid worst-case scenarios and make better forecasting and budgeting decisions, a good place to start is by understanding business risk basics.
Defining Business Risk
The Stanford Graduate School of Business defines risk as the likelihood and severity of loss caused by unexpected or uncontrollable outcomes. What this means concretely plays out differently in different business contexts.
In the broadest sense, business risk can be defined as factors that can inhibit an organization from achieving its objectives and goals. More specifically, business risk typically refers to the prospect of a company being less profitable than anticipated or suffering a loss. In the case of extreme unprofitability, this amounts to the risk of a company going bankrupt.
From an investors’ perspective, risk translates into the risk of a stock issuer being prevented by adverse economic conditions from meeting its operating expenses, which is how NASDAQ defines risk. Lenders may view companies in terms of credit risk, one aspect of risk covered in depth in Moody’s Analytics seminars on specialized risk analysis. Risk may also be defined in other senses, such as legal risk, risk to a company’s reputation or security risk.
All these definitions of risk are valid in their appropriate contexts as long as you have a clear idea which type of risk you’re talking about. Here we’ll focus on the risk of unprofitability.
Business risk can arise both from internal factors within an organization and external factors outside the company. Examples of internal factors include budgeting decisions, spending decisions, sales activity and volume, and per-unit pricing policy. External factors include input costs of materials and labor, market demand, competition, economic conditions such as inflation or unemployment, and government regulatory and tax policies.
Writing in Harvard Business Review, Ohio State University finance professor Rene M. Stulz identifies six risk management mistakes companies make that can aggravate these internal and external risk factors. Relying on outdated historic data made obsolete by innovation can skew companies’ ability to project future trends accurately. Measuring risk too narrowly by focusing on a single variable such as Value-at-Risk can fail to factor in other important influences. Overlooking risks that fall outside the box, such as those incurred by hedging, can set a company up to be blindsided. Concealed risks that go unnoticed because someone in your company failed to report them can creep up on your business. Failing to communicate risks clearly to management because the data is too technical for non-experts can lead to poor corporate decisions. Finally, not keeping up with changing data can lead to bad decisions based on outdated information.
Effectively managing risk begins by making an accurate risk assessment, a task best done by a professional using specialized software. Once risk has been assessed, a key to avoiding unprofitability is choosing a capital structure with a low debt ratio (also known as leverage) to ensure that sufficient capital is always available.
Capital structure is determined by long-term debts such as bond issues and notes payable, short-term debts such as working capital, preferred equity, and common equity. As the Business Encyclopedia explains, capital structure and debt ratio tend to change gradually over the long term, but in the short term, a company can decrease its debt ratio and increase its equity by issuing and selling new stock shares. Successful companies will gradually reduce their long-term debt over time as profitability increases.