The threat that a firm may no longer be able to operate as a going concern
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Business risk is a component of total risk. Business risk represents the notion that a firm may experience events or circumstances that create a threat to its ability to continue operating.
A firm’s management team is regularly tasked with making decisions about how to grow and operate a business. However, every decision about a new product offering, a new target market, or a potential merger (and many other examples) has the potential to fail and put the company’s ability to operate at risk.
Business risk is the threat that internal and external forces may converge to create an environment in which a firm is no longer viable.
Business risk is different from financial risk, which occurs when a company employs significant debt in its capital structure.
A variety of tools and frameworks exist to help understand and measure business risk.
Understanding Risk – Business Risks vs. Financial Risks
Broadly speaking, risk can be split up into two main categories – financial risk and business risk.
Financial risk comes with the use of leverage (sometimes called gearing); it occurs when a company has a heavy reliance on debt as a funding source.
Liquidity becomes a much bigger concern for a management team that borrows, as principal and interest payments must be made to service its debt obligations. A company that uses debt in its capital structure becomes susceptible to rising interest rates and is required to adhere to the terms of its various credit agreements.
Financial risk represents the notion that a company’s commitment to meet debt service obligations, as well as potentially onerous covenants and reporting requirements, could push the firm into an event of default.
Business risk, on the other hand, is about internal and external forces that converge to create threats to a company and its management team. These threats could emerge from:
The external business environment, including macroeconomic forces well outside the control of management (like inflation, foreign exchange rates, or prevailing interest rates).
Industry-specific risks, like the level of concentration in the industry, regulatory risk, barriers to entry, the threat of disruption, and other factors.
Company or firm-level concerns, like ineffective management, reputational risk, a toxic corporate culture, and customer or supplier concentration risk.
Company Life Cycle
Understanding the stage of a company’s life cycle can help analysts quantify the relative levels of business risk and financial risk. As illustrated in the image below, debt becomes a larger source of funding as a company progresses through its lifecycle (once the firm earns a healthy profit and has sufficient cash flow to service debt obligations).
Early in a company’s life cycle, there’s no real opportunity to use leverage (or debt) – these businesses are typically equity-funded, precisely because business risk is very high. Early in a company’s life cycle, the product-market fit is unknown, the size of the target market may be unclear, barriers to entry may be high, and so on.
The relative relationship between business risk and financial risk can be visualized as follows, with business risk being the orange line and financial risk being the blue one:
Business risk is highest early in a firm’s life cycle, but quite low later on. Implicit in this is that if a firm achieves maturity, there is obviously a proven product-market fit and a viable business model.
The inverse is true of financial risk. It’s low early on since debt is typically not available, then it gets progressively higher (peaking in the “decline phase” as sales decrease and margins begin to erode).
Examples of Company-Level Business Risks
Company-level business risks are typically tied to a firm’s strategy and operations. Company level business risks include countless subcategories of potential threats; they include (but are not limited to):
How viable a company’s business model is.
How good the product-market fit is.
How effectively management is able to identify and reach its target market.
There are many tools and frameworks available to management teams and the analyst community that can help assess and quantify business risk. We’ve organized some of these into two buckets:
Economy, Business Environment, and Industry
PESTEL Analysis – Stands for Political, Economic, Social, Technological, Environmental, and Legal. The framework seeks to understand factors in each of these 6 buckets that may create opportunities or risks for a business.
Porter’s 5 Forces – An analysis tool that helps conceptualize the attractiveness of a particular industry, measured against factors like barriers to entry, customer and supplier bargaining power, and the threat of substitute products or services.
Competitive positioning and competitive advantage help us understand how a business looks to differentiate itself from competitors. A tool like Hax’s Delta Model is a useful framework to accomplish this.
Ansoff’s Matrix – Sometimes referred to as the Product-Market Expansion Grid. The framework helps analysts quantify the relative risk of different growth strategies.
SWOT Analysis – SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. Strengths and weaknesses are characteristics of a business that put it at a relative advantage or disadvantage (respectively) over its competitors. Opportunities and threats are elements in the external environment that may present areas for growth or significant risk to a specific firm.
Thank you for reading CFI’s guide to Business Risk. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:
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