Business risk implies uncertainty in profits or danger of losses on account of internal and external decision and events. The risk is inherent in every area of business activity and varies according to the nature and size of business. Some examples of risk are an irregular supply of raw materials breakdown of machinery, price fluctuations, errors in sales forecasting, trade cycles, natural and manmade disturbances etc.
Risks are inevitable and cannot be eliminated but only controlled through proper preventive and corrective measures of risk management. First, it is Important to sort the risks faced in business to know them better.
Risks can be classified across three dimensions;
A. Source of risk: on the basis of the origin or source of the risk, they can be classified as internal and external risks.
B. Nature of risk; on the basis of the nature of risks, they can be classified as strategic, operational compliance and report risks.
C. Risk domain: risks can be categorized on the basis of the domain or the subject –matter, the list of these risks will depend upon the company and its business. A few key domains that can be seen to exist in all firms are liquidity risk, credit risk or default risk, market or price fluctuation risk, reputational risk, supply chain risk business continuity risk, environmental risk, physical security risk and cybersecurity risk.
D. Risks based on source: internal and external. Here we discuss risks originating internally and those arising from external sources.
Internal risks
These risks arise from the events and decisions of the organization. Some notable internal risks are
1. Human actions and lapses
employees and other stakeholders of the company cause significant internal risk through their deliberate or accidental action or inaction. Strikes, Lockouts, Theft, pilferage and sabotage, accident, supplier failures, customer insolvencies, wrong management decisions etc. are some examples.
2. Technology Failures
These include investing in wrong technology, blunders in the production process, product design mistakes, inability to cope with the market requirement of technology, lagging behind completion in product development etc.
3. Physical occurrence
Manmade happiness can result in loss or damage to the property, like machinery breakdown, and fire, flood or earthquake losses, transit damages, third party loss of life or property etc. which the company has failed to ensure.
External risks
Risk arising from events outside the organization are external risks. These events are far more difficult to predict, measure and control
1. The performance indicators of the company have a bearing on individual company fortunes.
2. Systematic risk or the collapse of the entire market or entire financial system being hampered is a variety of external risk.
3. Customers vendors and competitors and their actions are crucial to the operations of a business and have a definite external risk element.
4. Interest rate changes, foreign currency fluctuations, and credit risks are major external risks.
5. Movements in the cost of living, industrial growth, stock exchange index, inflation, and recession, unemployment etc. impart businesses in general and particular, depending upon how closely related the business is to the factor.
6. Natural factors like earthquake, cyclone, famine, and drought may cause loss of life and property to an organization.
7. Change in government and government policies, communal violence and interstate squabbles can seriously hamper the working of an organization.
Risks based on nature of risk- strategic, operational, compliance and reporting risks
The different stages of management action viz. planning the strategy, execution, administrative matters and communication with stakeholders. At each stage, the management faces a set of risks.
1. Strategic risk
Strategic risk refers to the business losing out on options available to it by taking a decision that preempts other paths. Risks arising from the strategy deployed by the firm and strategic decisions taken are of two kinds:
a. Structural strategy decisions
The approach of the firm with regard to technology, market, product diversity, expansion etc. are fundamental structural decisions and the risk of any of these going wrong is a strategic risk.
b. Executive strategy decision
The approaches of the firm with regard to processes, systems, transactions, management style, employee management etc. are the of operational aspects of strategy.
These also are strategic risks.
c. Operational risk
A number of operational decisions are required to be taken in a business day to day. Each of these has a risk element varying with the monetary value of the decision and time period for which the decision may impact the business. For instance, a decision to give an employee advance may be seen as a small, one-time commitment and so not risky; but other employees may set it as precedent and then it becomes a significant risk.
d. Compliance risk
The risk of failure is complying with the rules can be a serious matter especially for companies with global reach, which have to understand and observe the rules set in as many countries as they are working in. These are risks of noncompliance with the rules and regulations that apply to the business, and the risk multiplies if the firm operates in many countries. Noncompliance often happens because of omission or ignorance of the law and is not intended.
2. Reporting risk
This is the risk that a public company makes accounting errors that reflect in the annual financial accounting report in the form of wrong profit /loss which causes an adverse reaction in the stock market. This is also the risk that a willful deviation in accounting and reporting by a company gets detected and the comp[any and its directors are penalized. The application of statutory standards and independent test of the reported figures by auditors to a large extent mitigates the first risk. But the second risk, the deliberate ‘creative accounting has gone up in the last decade. Risks of reporting are threefold
a. Failure to report
Depending upon the nature of the report or disclosure this risk can be costly or small.
b. Undesirable effects of reporting
At times voluntary reporting by key corporate cab boomerang on them. An example is the financial guidance or forecast of net income for the succeeding quarter.
c. Mistakes in reporting
The risk of having to retract reports issued can sometimes play havoc with the reputation of a company.
3. Domain-specific risks
Classifying business risk into the domains in which they occur is a good way to assign responsibility for managing them. The bigger the domain, the higher is the risk factor. For instance, a company in consulting services will have no inventory risks but the sizeable market and competitor risk.
Here are some domain risks common to all businesses:
1. Sale and production risks
The two biggest threats to any business are not the availability of a market for their product and incapability of fulfilling the demand. Inability to solve is the first and last reason for business failure. The risks of the misjudging market, competition and customer behavior can prove fatal to the business. Production risk relates to the quantity, quality, and cost of manufacture. Production quantity is usually well planned and controlled but could go awry. Excess production can give rise to huge inventories and eventual disposal at a loss. But production falling short of demand is an even greater risk.
2. Employee risks
An organization’s success depends upon employees, a key resources. Hiring people introduces several types of risks:
a. Risk related to the job
A job that calls for late night work, like a BPO, and with female workers, raises risk likes health hazards, accidents and high level of attrition.
b. Risk related to human behavior
Trade union relations, interdepartmental rivalries, managerial issues like appraisals etc. are all matters that pose a threat and carry a risk element.
c. Risk related to the handling of employee relations
Employee engagement, viz getting the best out of your workforce, is not only about high salaries but the sensitive management of employee relations. This includes work environment, supportive employee policies, systematic reskilling.
3. Financial risks
There are risks associated with the financial structure of the company and financial transactions
a. Capital structure
This is the proportion of owned and borrowed capital, also called the external of leverage, and is a significant risk indicator. The higher the debt portion of the capital, the greater is the risk.
b. Investment risk
This denotes the risk of poor returns on a complete loss of investments made with the capital sourced. It is easy to perceive when a single big investment fails; but the risk that is much harder to see, and therefore control, is the persistent fall in return on investment compared to the cost of capital
c. Liquidity risk
Inability to pay for maturing liabilities is a grave financial risk that can sometimes result in the closure of a firm.
d. Default risk
This is a variety of liquidity risk and deals with the risk of defaulting on a loan servicing liability. Default risk occurs when the companies cannot pay their debt obligations. Most lenders and investors are exposed to default risk, lenders often charge return rates corresponding the debtor’s level of default risk.
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