What is commercial risk?
Business risk is the exposure of a business or organization to factors that will reduce profits or lead to failure.
Anything that threatens the ability of a business to achieve its goal or achieve its financial goals is called business risk. These risks come from a variety of sources, so it’s not always the business owner or manager who is to blame. Instead, risks can come from other sources within the company or they can be external – from regulations to the global economy.
While a business may not be able to fully protect itself from risk, there are ways to protect itself from the effects of business risk, primarily by adopting a risk management strategy.
Understanding business risk
Commercial risk is associated with the overall functioning of a commercial entity. These are things that affect its ability to provide investors and stakeholders with adequate returns. For example, a business owner may make certain decisions that affect his profits or he may not anticipate certain events in the future, resulting in losses or business failure.
Business risk is influenced by a number of different factors, including:
- Consumer preferences, demand and sales volumes
- Unit price and input costs
- The global economic climate
- Government regulations
The company is also exposed to financial risk, liquidity risk, systematic risk, currency risk and country-specific risk. It is therefore increasingly important to minimize business risks.
A company with higher commercial risk should choose a capital structure with a lower debt ratio to ensure that it can meet its financial obligations at any time. When revenues decline, the business may not be able to repay its debt, which can lead to bankruptcy. On the other hand, when income increases, it records higher profits and is able to meet its obligations.
To calculate risk, analysts use four simple ratios: contribution margin, operational leverage, financial leverage and total leverage. For more complex calculations, analysts can integrate statistical methods. Commercial risk generally presents itself in four ways: strategic risk, compliance risk, operational risk and reputation risk.
Specific types of business risks
Strategic risk arises when a business does not operate according to the business model or plan. A business strategy becomes less effective over time and it struggles to achieve its defined goals. If, for example, Walmart strategically positions itself as a low-cost supplier and Target decides to undercut Walmart prices, this becomes a strategic risk.
The second form is compliance risk. This occurs in industries and sectors that are heavily regulated by law. The wine industry, for example, must adhere to the three-tier distribution system, where a wholesaler is required to sell wine to a retailer, who in turn sells it to consumers. Wineries cannot sell directly to retail stores.
However, 17 states do not have this type of distribution system, and a compliance risk arises when a brand does not understand individual requirements, thereby becoming non-compliant with state-specific distribution laws.
The third type of commercial risk is operational risk. This risk comes from inside the company, when the daily operations of a business do not work. HSBC, for example, faced operational risk and a heavy fine when its internal anti-money laundering operations team was unable to put an adequate end to money laundering Mexico.
Whenever a company’s reputation is ruined, either by one of the previous business risks, or by something else, it runs the risk of losing customers due to a lack of brand loyalty. Coming back to HSBC, the company faced the high risk of losing its reputation when the $ 1.9 billion fine was imposed for poor anti-money laundering practices.
[Important: There are still other risks that can occur infrequently such as natural disasters and weather-related issues for which companies still need to account.]
Key points to remember
- Commercial risk is any exposure of a business or organization to factors that will reduce profits or lead to failure.
- Commercial risk comes from a variety of sources, including consumer taste and demand, the global economy and government regulations.
- While companies may not be able to completely avoid risks, there are steps they can take to mitigate their impact, including developing a strategic risk plan.
How to Avoid Business Risks
Although the business risk cannot be avoided as a whole – as it can often be unpredictable – there may be ways to reduce the impact:
Identify the risks. Part of any business plan should be to identify and analyze any potential threats to the business. These are not only external risks, they can also come from the company itself.
Do not wait. Taking action to reduce risks as soon as they arise is essential. Management should come up with a plan to deal with it head-on before it explodes.
Record the risks. Once management has developed a plan to deal with the risk, it is important to document everything in case the same situation occurs again. After all, risk is not static – it tends to repeat itself during the business cycle.
Risk management strategy. It is an important factor in any business. Developing a strategy, whether before the start of the business or after a failure, will help the business get through the ups and downs, making the business better prepared to deal with risks when they present themselves. The plan should have tested the ideas and procedures in place in case the risk arises.