Business risk is the risk that a business' future operating profits may drop due to adverse changes in operations. Business risk arises from fluctuations in the business' revenue and is magnified by the business' operating leverage.
There are two types of business risk—sales risk and operating risk:
|Business Risk = Sales Risk + Operating Risk|
Sales risk is the risk of drop in revenue while operating risk is the risk of adverse movements in costs. The higher the ratio of fixed costs of a business to its total costs, the more the fluctuation in the business' operating earnings (i.e. earnings before interest and taxes).
While business risk refers to potential adverse variation in operating income, financial risk refers to the risk of adverse movement in net income due to the effect of capital structure.
Business risk is quantified using ratios such as breakeven point, contribution margin ratio and degree of operating leverage.
Asset beta is a measure that calculates the systematic business risk of an investment.
Rio Tinto Group is a British mining corporation. It has significant operations around the world and is one of the largest producers of aluminum, iron, copper, uranium, etc.
Following are some of the factors that affect its business risk:
- The stage of the business cycle: recession means lower demand for raw materials and lower sales volume. Lower demand also means lower price. All this translates into lower sales.
- The yield of the mines: a drop in this yield means less production and higher costs which results in lower revenue and lower profit respectively.
- Government regulations such as legislation related to minimum wage and environmental obligations: higher minimum wage and more cleanup costs, etc. means higher operating risk and lower profits.
- Employee relations: strikes at mines and low employee morale means less efficiency, higher costs and lower profits, etc.
Written by Obaidullah Jan, ACA, CFA