All businesses are prone to risks and the potential of adverse effects that might reduce profitability. The risks occur at different levels of organizational operations with varying degrees of impact. The concept refers to a company’s exposure to factor(s) that might negatively affect its profitability. It is the potential loss caused by unfavorable changes in the volume of the business output, costs, and profit margins. Business risk threatens the ability of an organization to achieve its financial objectives. When it occurs, the firm is unable to operate optimally and can face challenges meeting its targets. The risk can be due to changes in customer preferences, increased pressure from competitors, or any other change in the operating environment. Besides, success in addressing the risk depends on the type of the organization and the ability to adapt the business policy or strategy to the changes in the internal and external environment (Sadgrove 15). Business risk in environments, such as banking, might overlap with other risks, such as managerial risk, which makes the effects worse. Although businesses face many critical issues in their operations, business risk is among the most significant operational challenges because of its impact on both profitability and sustainability.
Business Risk Definition
Business risk is simply exposure to a factor(s) that might reduce profitability. The factors occur at any point in the course of a firm’s operations and can have diverse effects depending on nature and magnitude. Such factors can also create ultimate failure because companies are established to make profits for their investors. Therefore, whatever factor might hinder the potential is a risk that management should assess, identify, and manage. Risks emanate from various places within and outside the organization. They are internal or external factors that might distract the effective performance of the firm. Therefore, it should be a manager’s responsibility whenever a risk occurs in the business (Sadgrove 5). Risks might come from many other sources external to the company, from regulation to the economy. Although organizations cannot be completely safe from risks, they have numerous mechanisms to use to protect or minimize the impact of the threat. Experts advise companies to have a risk management strategy to help in addressing the effects of risks in their businesses.
Understanding Business Risk
Business risks have an overall effect on the operation and performance of a business. Although the impact differs depending on the type and magnitude of the risk, managers need to understand such risks to implement effective measures to address them. Business risks are internal and external forces that might impair the ability of a company to provide adequate returns to stakeholders and investors. They affect the capacity of a business to add value to its stakeholders (Engemann and Henderson 35). For instance, the management might make decisions that affect the strategic direction of the organization and affect the amount of returns it acquires in a financial year. The company might also anticipate some changes in the future that might affect the company’s performance in the following financial period. Such changes might make the business experience failure or losses if they are not identified and mitigated timely. Therefore, companies should always be keen about potential factors that might affect their operations favorably or unfavorably. They should make strategic decisions accordingly to protect their companies from the serious effects of risk factors.
Various factors influence business risk in multiple environments. First, consumer preferences and demands might change in the course of the business operations, which affect sales volumes. Secondly, the firm might experience changes in the per-unit price and input costs, which increase the production cost and reduce the level of profitability in the company. Thirdly, a business might experience an increase in competition, which means that it will share its market with others and reduce sales revenue. Fourthly, the company might be affected by changes in the overall economic climate, which affects the level of revenue and profitability. Finally, government regulations might change to become stricter and affect a firm’s operations. All the sources of risk are important for management because they affect operations and productivity. The relevance of the risk depends on various factors, such as economic, political, technological, social, and environmental (Engemann and Henderson 35). The management should understand their internal and external environments to mitigate any potential changes that might hinder their positive performance.
People assuming different careers should understand the effect of business risk on their future operations, whether they work in companies or pursue entrepreneurship. The risks affect operations differently depending on the type of the industry. In addition, the magnitude of the risk might differ depending on the internal and external realities of the business. Decisions to comprehend business risk depend on the anticipated implications on operations. After all, decisions to take on risk depends on the kind of person assuming the risk, the nature of the profession (such as engineering), and the type of operating environment. The challenges are symptomatic of the kind of business. For example, some businesses are more risk-tolerant than others. Therefore, managers take into consideration the nature of the business to determine the potential implication of business risk. Such a factor is critical because businesses cannot avoid risk (Kozubíková et al. 42). Entrepreneurs and business managers should understand the level of risk that is safe to prevent adverse effects, such as reduced profits or even failure.
Understanding and managing risks are critical aspects that protect business value. Researchers suggest that protecting business value is a crucial factor in the success of any organization (Rebelo et al. 395). Therefore, managers should ensure that they manage, prevent or mitigate any factors that might cause challenges in the business’ potential to add value for the sake of its stakeholders, such as investors, customers, and suppliers. The beginning step is to comprehend the types of risks that exist to implement effective mechanisms to address them. After all, experts have proposed effective means to address risks in business. Therefore, amid the negative factors, organizations can still overcome them to remain profitable and valuable to their stakeholders. They should have a harmonized process of risk identification based on the nature of the organization because they differ in their operations and factors that affect their performance (Rebelo et al. 395). Companies contend with various types of risks that affect their success and profitability and should implement successful mechanisms to address them. Some of the common risks may include competitive risk, economic risk, operational risk, legal risk, competition risk, strategy risk, compliance risk, reputation risk, and program risk.
Competition Risk
The level of competition in the market affects business operations. It is a major type of risk that managers and entrepreneurs should understand to ensure that their operations are competitive. Competition has a huge impact on the level of profitability. The risk of competition has a significant effect on the stability of an organization. Considerable literature is available regarding the impact of this factor on the performance and stability of banks and other financial institutions. Companies contend with current and emerging competition in the market. The traditional “competition-fragility” perspective suggests that an increase in the number of such organizations in the same region or market affects the market power (Berger et al. 4). Another impact of the situation is a reduction in the level of profitability and lower franchise value. Banks and other similar organizations operate in such a way that they should add value to their stakeholders and investors. However, the risk of competition might affect the level of profit margin and reduce value.
Management should understand the level of competition in their markets to create a strategy to counter the competition and remain profitable. In the banking sector, risks are critical for the success of the business. For example, to counter the level of competition, organizations might be forced to take more financial risks, such as additional debts to support their operations and improve profitability. For instance, banks made relevant changes in the 1980s due to the relaxation of state branching limitations in the United States. The changes led to increased competition and deregulation, which also reduced monopoly rent. However, many banks failed as a result of the increased competition that reduced the level of profitability for the institutions. The emergence effect was as a result of removing interest ceiling on deposit eroded franchise value (Berger et al. 4). It would also encourage negative behaviors from banks to remain operational and profitable. Competition is good for business, but it can also cause a severe negative effect on the value that business adds to its stakeholders.
High competition in business causes managers to pursue alternative means to remain profitable and afloat. A highly concentrated market for various companies encourages them to pursue extreme measures. For example, in the banking sector, high competition leads to significant risks, especially among the institutions that believe that they are too big to fail. To avoid such a negative outcome, they might pursue other costly and detrimental strategies, such as taking external debts to finance their operations. Research shows that imminent failure is common in such organizations. Most banks fail in concentrated markets more than in other setups, which have fewer operators (Berger et al. 5). While they might be willing to help their institutions to remain afloat, business owners might lack the necessary incentive to control the competition risk. Generally, the risk of competition operates from outside the organization and the only solution for such businesses is to implement internal strategies or mechanisms to remain afloat. Organizations can only counter competition from within the company by creating effective strategic plans.
Economic Risk
Economic factors affect the operations of a business. Therefore, whenever economic factors change in the market, the management should make relevant changes to mitigate economic risk. Economists make appropriate decisions depending on the nature of the business because firms differ in how they are affected by changes in the economy (Sjöberg and Engelberg 33). Besides, companies should operate with a high level of consciousness regarding their business risk propensity. For example, companies with a high level of risk should use a low debt ratio capital to mitigate the risk and related effects. Such decisions also help the company to meet its financial obligations comfortably to avoid economic risks. Otherwise, if the revenue of the company drops, it might be hard to service its debts adequately. Conversely, an increase in revenue means that the business might experience more substantial profits and service its debt obligations adequately (Cornett and Saunders 25). Therefore, the management should decide based on their risk propensity and the nature of the firm because economic factors affect operations differently.
In terms of economic risk, the management should be capable of calculating the risk to make accurate decisions. Business analysts use ratios to determine the level of financial risk in their companies. The commonly used ratios are total leverage effect, operation leverage effect, contribution margin, and financial leverage effect. However, businesses can apply complex financial calculations if they experience higher levels of risk. One of the common causes of economic uncertainty in companies is external changes in the market (Cornett and Saunders 29). For example, a recession is a severe risk for companies operating in all business environments. Financial conditions in a country have a serious effect on the success of a business, including the ability to make profits. Some researchers consider the issue of financial risk propensity when assessing the effect of economic changes on the organization. Some businesses are more stable and can overcome the impact of such changes, while others can quickly fail due to the pressure.
Notably, companies might not control the economic performance of their countries. They can only experience external shocks without much effect on the economy. However, they should create effective financial policies to help them to overcome the changes in the economy and related effects on their ability to operate profitably. Management should design and implement portfolio risk exposure to address changes in the economy of their market or country. Research indicates that businesses have a high-risk propensity when the economy is performing positively. The opposite applies when the economy is experiencing adverse shocks (Bucciol and Miniaci 160). Therefore, the business should always create a strong financial base within to overcome the external challenges that emanate from financial problems. For example, companies with a strong capital base might be relatively safer during a recession compared to those with a low capital base. Businesses should always prepare for negative and positive changes in the economy.
Operational Risk
Operational risk is another kind of factor that might threaten a company’s profitability. The threat is defined as the risk of loss that emanates from challenges related to internal controls, people, systems, and external issues. It can occur at any stage in the business operations because firms are affected by numerous internal and external forces. The Basel Committee suggests that such risks are evident in all business environments, including in financial organizations. Managers in such organizations are challenged to ensure that they are properly structured to address such incidents that might cause an operational risk. Operational costs are typical in settings, which are very demanding and require outcomes with short deadlines. Conceptual and practical frameworks also help them to deal with such risks to implement operations effectively and avoid emerging issues that could affect the production process and expected results (Cruz 1). Therefore, executives should have an effective strategy to prevent, reduce, or minimize operational risk and ensure that the business remains profitable.
Operational risks are evident in all business operations. Research has focused on how the risk occurs and affects companies in the banking sector (Uhl and Gollenia 87). According to his study, until the “Basel 2” banking supervision reforms, such factors remained a residual class of uncertainties and risks that were challenging to assess, manage, and insure using conventional risk assessment and management models. However, after the reforms, the operational risk realm in the banking sector expanded rapidly and became an institutionalized element in the regulation of banking and other financial operations. Nevertheless, the risk in the financial sector experiences tension because it exists between auditing and finance to establish factors that might affect the profitability of banks. Regardless, operational risks are critical in the sector and other settings because the effective functioning of the sector depends on how well the management runs (Uhl and Gollenia 87). Any potential factor that affects operations can create challenges in the profitability potential.
Legal Risk
Businesses experience the risk of legal problems emanating from their operations and relationships with internal and external stakeholders. According to Basel II classification, legal risks emanate from threats to the operational aspect of the company. It is a perspective, which recognizes that some threats are associated with the business operating environment. Businesses operate in an environment with other people who relate from different levels, internally and externally. They interact in the pursuit of opportunities to exploit as well as their engagement with other individuals and organizations. Therefore, their operations can be subject to legal liability due to conflicts or other negative factors related to their operations. Legal liabilities and obligations are common in all businesses as well as other sectors (Chapman 435). Legal risk also takes numerous forms from employment problems to fraud, to negative customer interactions. They involve some legal violations associated with business operations.
Legal risk is defined as any threat of loss that emanates from a violation of the law. Various types of legal risks may exist. Firstly, a company might face a legal issue created by a defective transaction. Secondly, they can face a claim which results in a liability for the business (Chapman 435). For example, a company can face a complaint or charge resulting from the illegal termination of an employee. Thirdly, a business can experience a risk arising from failure to take suitable measures for the protection of assets, such as intellectual property. A general legal violation or a change in the law can also cause a legal problem for a company. Such risks require effective mechanisms to control and prevent legal damages to the firm. The management should understand the legal requirements at all levels of the business operations to avoid legal problems (Chapman 436). For example, they should learn the legal ways of interacting with internal and external stakeholders, such as employees, suppliers, and customers. Such knowledge is critical to protect the business from legal liabilities or obligations.
The main reason experts associate legal risks with business operations is because the liabilities and obligations occur in the course of the daily functioning of the business. For example, fraud is one of the common types of legal challenges that affect businesses across sectors. However, it does not mean that this is the only conceptualization of legal risks because many other potential violations of the law occur (Chapman 436). Companies experience specific sets of legal risks that they should understand and implement mechanisms to prevent or minimize their effects. Legal issues in business have serious ramifications for a company because of other related threats such as financial costs and a damaged reputation. For instance, a company with a negative reputation due to a legal case can experience a loss of customers and investors. Generally, people and other businesses avoid their association with companies that have a negative reputation. Besides, such a company could face financial ramifications, such as the need to pay for damages or a fine required by the court of law following a legal case.
Strategic Risk
Strategy or strategic risk is another common type of risk that businesses in various sectors face and should manage effectively to remain profitable. Such risks emanate from situations where the company is unable to operate according to its strategic plans. The firm might fail to work according to the strategic model created during its onset. The strategy might also become less effective as time passes, and the firm might struggle to achieve its organizational objectives (James 17). For example, a retail store might position itself strategically to operate as a low-cost provider while a competitor may decide to undercut the firm’s prices. The decision by the competitor becomes a strategic risk for the first company. Understanding strategic risk is important in business because stakeholder value emerges from the ability of the business to operate according to its strategic direction. An effective strategy attracts people to associate with the business, such as investors. Therefore, failure to operate according to the direction becomes a threat to the company’s success.
Changes in the regulatory and stakeholder expectations, since the beginning of the 20th century, created significant reforms and growth in the importance of the strategic risk in all businesses. The strategy of the company determines its ability to succeed and to overcome other risks, such as increasing competition and operational risk. Firms experience numerous types of strategic risks. Firstly, businesses whose corporate cultures fail to emphasize integrity can experience strategic challenges due to a failure to operate ethically. Secondly, an organization should operate in an environment that aligns with its goals and objectives. Failure to achieve such congruence can also result in a strategic failure for the business. The management should understand the business environment and create strategies that help them to operate profitably in the environment (James 72). A successful plan depends on the type of market in which the company operates.
The management should create a realistic strategy that will be easily realized using available resources. Failure to address strategic risks can bring other threats to the business, such as regulation and compliance risks. Unfortunately, failure to initiate a suitable strategy and implement measures to achieve it can cause complete failure of the business. An ineffective strategy or inability to address strategic risk can also affect the business’s ability to add value to its stakeholders. They can also affect shareholders experience in the market, which can further cause challenges in attracting customers and investors. Such problems create a reduction in profits or ultimate failure because businesses exist to add value to the stakeholders (James 37). Inability to achieve the objective may create liabilities for the business. Most companies experience huge losses because of failure or inefficiency in managing strategic risks. Therefore, managers should understand and manage internal and external threats to the achievement of the strategic plan.
Compliance Risk
Compliance risk is another type of business risk. The risk is more common in some businesses and industries compared to others because of the high demand for compliance. The most affected companies are those that are highly regulated by the law (Sadiq and Governatori 265). For example, careers such as engineering are more likely to experience higher levels of compliance risk because of extreme regulation. Others, such as the wine industry, also operate in a high-standard setup. Companies operating in the environment undergo a three-tier system of distribution. The law forbids them from selling directly to the consumer. Firms doing such business should comply with the legal standards. However, they face the risk of violation, especially when working with employees who might not understand such requirements.
Many of the rules and regulations are implemented in the market or industry level to ensure that companies operate ethically. Therefore, risk of compliance is sometimes referred to as integrity risk because it involves failure to operate ethically or fairly. Compliance risk also falls under the domain of corporate social responsibility and the importance of businesses to ensure that they protect people, the environment, and society in the course of operations. Another crucial area concerning compliance is the need for accountability in financial operations, especially in businesses, such as banks and insurance companies. Legislation, such as the Sarbanes-Oxley Act, was initiated to ensure that organizations maintain a high level of accountability in financial reporting (Sadiq and Governatori 266). The need for compliance affects various stakeholders, such as shareholders or investors, suppliers, and customers. A business should maintain a high level of ethical standards when working with different stakeholder groups or risk facing a threat to their performance and profitability.
Although compliance relates to ethical operations of a business, it has legal ramifications in the case of violations. Companies face the risk of financial damages and fines if a violation ends up in a court of law. Others might involve alternative resolution procedures, such as negotiation or mediation. Besides the legal ramifications, lack of compliance can affect the relationship between a company and its key stakeholders, such as suppliers and customers. It can make people avoid entering into contractual arrangements with the affected business. For example, suppliers can fail to supply goods to a company that faces a compliance-related scandal. Worse still, customers can avoid such an activity, which affects its sales revenue and profitability. An organization’s loss of reputation can make the company lose significant opportunities and fail to add value to stakeholders. Therefore, the management should create a culture that respects the rules and regulation (Sadiq and Governatori 266). Firms should have a policy that requires compliance among their employees and other internal stakeholders, including investors. Such mechanisms will play a critical role in protecting a firm from the adverse effects of compliance risk.
Reputational Risk
Reputation is critical in businesses when interacting with stakeholders, such as shareholders and customers. Companies consider their reputation as an important aspect of their successful operation. Hence, firms require investors’ confidence and customers’ loyalty to remain in operation. Reputation concerning investors focuses on market capitalization as well as share price. Besides, reputation with other stakeholders, such as suppliers, employees, and customers, play an important role in determining the success of a business. Without all the stakeholders playing their roles, the business would cease to exist. Many of the stakeholders create value in the business. Therefore, any factor that threatens the ability of the company to maintain a positive reputation among the individuals and groups is a risk that the management should understand and mitigate (Gatzert et al. 641). Organizations should ensure that all types of reputations with diverse people are protected to maintain both profitability and productivity of the business.
Some businesses have a higher risk of reputation loss than others because of the nature of their operations. For example, grocery chains require reputation among their customers and suppliers because they depend on these stakeholders for their successful operation. They should ensure attractive retail prices to appeal to more clients and make high profits. At the same time, they face a high risk of damaged reputation when relating to their customers. Any minor mistake can affect their image negatively (Gatzert et al. 641). For example, they can sell a faulty product, which might attract negative customer reviews. The risk is even higher in the present age of social media because customers share information faster and across an extensive geographic coverage. Poor reputation with customers will automatically affect sales revenue and profitability. Overall, it will also diminish the value of the business to its key stakeholders.
With the increasing loss of finances in major companies across the world, reputation risk has become particularly important. For example, BP lost firm value to its shareholders. Another case in point is the reputational effect of the 2010 Gulf Coast oil spill (Gatzert et al. 641). Notably, financial institutions are facing significant scandals, such as the opening of fake accounts in Wells Fargo. Such examples indicate the growing importance of the reputation risk and related adverse effects of a negative image of a firm. Reputation-damaging events have substantial cost implications for the affected companies because clients and other stakeholders tend to avoid businesses with a negative reputation. Therefore, managers should ensure that they are cautious regarding their fundamental organizational activities to prevent scandals and other events that might affect their reputations. Experts insist on the importance of managing organizational reputation through policies and programs that involve all employees. Such measures will protect the firm from negative effects or potential failure.
Program Risk
A project risk is an uncertainty that occurs in the course of an organizational project or program. The Project Management Institute (PMI) defines the concept as any uncertain condition or event that might have an impact on one or more of the project objectives. The risk might affect the cost, scope, or quality of the final deliverables. Experts indicate that program risks can have either a negative or a positive effect on the outcome. Although the impact can be either way, the project team focuses on mitigating the adverse effects than managing the positive impact (opportunities) (Uhl and Gollenia 224). After all, the negative effects are undesirable. While they cannot ignore the negative effects, lack of attention to the positive side can lead the team to miss opportunities to improve the results. The project team should be aware of the risks and create mechanisms to mitigate them and prevent their adverse effects. At the same time, they should understand the opportunities to improve project success.
The management of program risks should consider the definition of programs because groups of interrelated projects are managed by a project team in a coordinated manner to achieve beneficial outcomes and controls that would be unachievable in individual projects. All business organizations undertake numerous programs to support their operations and achieve goals. Therefore, they face program risks that should be addressed adequately to meet their goals. When implementing a program in a business, the team must identify potential risks that might hinder positive outcomes. Program risks should be identified as early as possible to prevent detrimental effects and related challenges on the business. For example, a program risk might affect the potential for the business to complete a program within time and budget. It also means that the company will suffer extra cost to generate the expected deliverables.
The project team should implement a risk management process to decide about the ways of approaching and conducting risk management tasks for organization programs. A risk management plan details the mechanisms to prevent possible failure of a program and related effects, including loss of investment in high-cost projects. Management should develop and implement risk management tools, which they can use to protect the organization. Researchers affirm that it is more cost-effective for the business to implement risk management strategies than to experience the cost of adverse effects of a failed program or project. Generally, companies invest in major projects to achieve both business and organizational objectives. For example, a firm might initiate an information system to support operations. Hence, failure due to program risk can create a significant financial loss for the firm. The outcome also includes a reduction in profits or even a potential failure of the business.
Conclusion
While some types of business risk are worse than others in terms of their effect, they all have detrimental effects on the business. For example, a legal risk can bring other issues, such as loss of reputation and compliance challenges. Such outcomes can have direct and indirect effects, such as payment for damages or fine and reduced profitability. Therefore, all risks are critical and affect businesses in all sectors, including banking and engineering. Whether individuals are developing a career, intend to be employed, or work as entrepreneurs, it is imperative to understand the implications of risk in their operations. For example, an engineer could be working on a construction project for a real estate company. Thus, such an individual should understand the implications of different risks, such as program risk, compliance risk, legal risk, and reputation risk because such risks affect their work and relationship with the company. Besides, companies should have a risk management strategy or policy covering all sources to prevent, mitigate, or minimize adverse effects. The management and employees should also understand potential risks and their effects on their business. Such knowledge would help to prevent various risks, including lack of compliance with laws, rules, and regulations within their industry.
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