Tuesday, 16 July 2019

UNDERSTANDING BUSINESS RISK - AN INTRODUCTION



In this introductory blog post, we will delve into the topic of business risks - a topic which perhaps not as close to the hearts of many business owners and directors/managers as it should be. Understanding Risk and, importantly risk management, should underlay the strategy, management ethos and daily business operations to ensure the highest likelihood of business success (and survival). 

This article aims to create awareness of risk management and the impact of risks on the business operations, finance, supply chain and procurement operations of a business.

Time to read: Approx 7 min

Introduction


Running a company or any type of business venture comes with different types of risks.  Anything that threatens a business or more specifically, impacts the ability of that business to reach its goals or targets or even threatens its continued existence, is in effect a risk to that business.  Business risks are associated with the operations of the business and how the internal or external environment might impact on the ability of the business to generate an acceptable (financial) return to its shareholders and investors.


What is Business Risk?



Investopedia defines Business Risk as "Business risk is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail", which is a very broad definition.


This definition will be further explained by way of examples in the following sections.

Types of Business Risk


Before merely jumping into a list of different business risk examples, it is important to understand the following:
  • Certain Business risks (such as macro-economic risks or strategic industry & competitive risks) can and do exist independently, whether your business exists or not. These risks are brought about by causal factors in the world economy, country economy and in the industry and can impact on all businesses operating in a specific country, industry or geography.
IT Risks
Fig1 - IT risks are on the increase due to higher dependency on technology supported business processes (Image by Pete Linforth from Pixabay )
  • Not all business risks are due to factors external to the business. Risks could originate:
    • Externally meaning from the outside of the business (e.g. inflation, legislation, natural disasters - i.e. these risks are affected or precipitated by external causes, which, in most cases cannot be controlled by management or staff and occasionally not even by the government),
    • Internally meaning from the inside - risks which could arguably fall within the ambit of management control e.g. 
      • process risk due to the type of processes used,
      • technology risk due to technologies used,
      • operational risk to the nature of business operations, 
      • inherent risk due to business type, 
      • theft by employees, 
      • the type of customers accepted, etc.
    • Both Externally and Internally: Sometimes an external risk can influence or lead to internal risks - e.g. higher than expected inflation could hypothetically lead to unpopular food price increases that could, in turn, result in labour unrest and strikes which in turn cause business interruptions and impacts on productivity.
  • Risk varies from one country to the next, between industries or business types and from one business to the next. Even when 2 or more businesses compete directly in the same industry and on the same market for the same product,  e.g.: 
    • A business that is fully funded by equity is not as exposed to the impact of changing interest rates as a business entity funded by local bank loans or off-shore bank loans (which could be impacted by both interest and foreign exchange riks),
    • Similarly, a business that manufactures its own stock with local raw materials will be less affected by shipping delays and strikes at the harbour compared to a company importing its stock or raw materials. 
  • Some businesses or industries are inherently riskier than others - The risk profile in industries with heavy equipment or industrial operations will be significantly different compared to risk profile in industries not mechanised. 
    • A cash-in-transit delivery company faces significant additional risks which are not applicable to most other delivery companies delivering more traditional products. 
    • A metal smelter or mine has a completely different risk profile compared to say an IT company providing cloud storage. In saying that, we are not implying that Cloud storage has no risk - the risk profile will be very different, comparatively speaking. However, the risk of e.g. staff death in a workplace accident should statistically be significantly lower in a Cloud storage environment than in heavy industry such as mining or a smelter. 

Some industries are inherently more risky than others
Fig 2  - Mining accident at a SA-based Coal mine. Source.


Operational risks
Fig 3 - The results of a workplace accident could be severe in some industries. Source.

Business Risks include, but are not necessarily limited to:
  • Competitive Risk - the risk that other businesses competing against yours gain a competitive advantage. This could include:
    • New competitors entering the market,
    • Competitors finding more cost-effective suppliers, which would result in a cost-benefit, or
    • Sourcing more technologically advanced products which have more market appeal, or
    • Time-to-market risk when it takes a company too long to get a product ready for launch and as a result, it loses first-to-market competitive benefit it could have enjoyed, or competing products launch first.
  • Compliance Risk - the risk that the business might contravene laws or regulations or have to incur additional costs to comply with such new legal or updated requirements. Examples include:
    • Occupational Health & Safety compliance, 
    • Environmental Compliance and 
    • Protection of Personal Information Act (POPIA) Compliance requirements (which is broadly similar in nature to the EU General Data Protection Regulations (GDPR).
  • Country Risk - the risk of operating a business in a specific country, which is uniquely tied to that country. E.g. in Zimbabwe and Venezuela some or all of the following symptoms:
    • Currency fluctuations,
    • Hyper-inflation, 
    • Currency devaluations,
    • Currency shortages. 
Currency risk and Hyper-inflation
Fig 4 -  Currency Risk in real-life - 100 trillion Zimbabwe note from 2008

  • Demand Risk - changes in market/customer demand from one reporting period to the next can result in inventory fluctuations, cash flow issues and assorted logistical challenges (excess stock-keeping from one period to the next, finding additional warehouse space to build up reserves, etc). 
  • Economic Risk - the risk that changes to economic conditions could impact on the business e.g.:
    • Exchange Rate Risk - The risk that high degree of variability (also called volatility) impacts on the value of business transactions and assets.
    • Interest Rate Risk - the risk that interest rates can increase (or decrease) contrary to expectation and lead to higher costs or expenses.
  • Environmental Risk - the risk that the activities of the business negatively impact on the immediate surrounds or broader environment (such as toxic spills, air or water pollution).  
Environmental risk
Fig 5 ArcelorMittal charged for releasing chemicals into the air and contravening license conditions

  • Financial Risk - the risk that financial factors could impact on the business e.g.:
    • Credit Risk - the risk that debtors fail to pay or settle their accounts.
    • Liquidity Risk - the risk that a company is unable to settle obligations or to meet short term financial demands as these come due.

  • Health risks - such as bird flue, swine flue, ebola, work-place smoking etc.
  • Human Risk - the risk that employees or management:
    • disrupt business operations due to absenteeism, 
    • do not comply with requirements or legislation,
    • are not sufficiently trained or incompetent, 
    • abuse alcohol or drugs which impacts on operations, 
    • cause financial losses through fraud, theft, riots or protests,
    • cause reputational damage through their deliberate or accidental actions.

    • This could include directors and officers liability, where directors or officers cause damage or claims against the organisation (whether willful or not).

  • Innovation Risk - the risk that applies to the innovative areas of your business, resulting in the business not staying up to date with technological developments. 
  • Intellectual property risk - the risk that your intellectual property is infringed or blatantly stolen by competitors (industrial espionage) or not properly protected by means of copyrights, patents, and trademarks or that your business infringes on the intellectual property of another that owns the copyright or patents. 
  • Legal Risk - the risk that changes in legal requirements or lawsuits impact or disrupts the business or results in claims or losses. 
  • Market Risk - the risk that consumer preferences might change and that demand for products or service wane, 
  • Natural Disasters - the risk of storms, floods, earthquakes, climate change and other similar natural events (so-called Force Majeure / Acts of God) causing damage or business interruptions.

Force Majeure risk
Fig 6 Inside an Airport hangar destroyed by Cyclone Idai


Fig 7 Significant damage to assets and business operations in Beira, Mozambique due to Cyclone Idai in March 2019

  • Operational Risk - the risk that the internal business processes and day-to-day business operations negatively impact on the ability to service clients optimally.
    • Business Interruption Risk - the risk that events occur that interferes with a company’s ability to function.
    • Process Risk - the risk associated with business processes in use. This could include process inefficiencies such as operational bottlenecks, or the "collateral damage" as a result of the nature of the process - e.g. working with heavy equipment or in a metal smeltery could result in injury or death if anything goes wrong.
    • Utility risk - the risk that water, electricity, gas or other services provided by the state or external service providers should fail or be interrupted. South Africa has experienced a wave of electrical loadshedding that has had a severe impact on the economy.
Utilities risk
Fig 8  Astral forced to halve production because of water interruptions at the Lekwa municipality in Mpumalanga.

  • Physical Risk - the risk of damage to assets or property from fire, theft or other events such as burst or leaking water pipes.
  • Political Risk - the risk that political events or developments could impact on the business operations. This could include the risk of terrorism or war.
  • Reputational Risk - the risk of losses (either quantifiable in cash or less easily quantifiable in the case of reputational damage) as a result of events or incidents which lead customers and or the public at large to perceive this business as unethical, incompetent or dishonest. These events or incidents could either be:
    • accidental (e.g. where a new product is very similar to existing competing products) or
    • intentional (where a conscious management decision was made to copy the design or performance features of a competing product).  
    • Repeated occurrences (regardless of whether intentional or accidental) will definitely be damaging to the corporate reputation - e.g. Ford's clumsy bungling of the Kuga crisis when a number of its Kuga vehicles caught fire and burnt out.
Copying of competitive products could lead to reputation risk
Fig 9 - Woolworths, a large South African retailer, has repeatedly been in the news over the last couple of years for "similarities" in their new products when compared to competing products launched earlier.

  • Seasonal Risk - also referred to as seasonality, which is the risk where a business sells products or services for which the demand fluctuates from one season to the other (ice cream) or for which the ability to deliver such a product or service is tied to a specific season (ski resort).  
  • Security Risk - the risk of physical security of assets, resources or IP due to fraud, or theft.
  • Strategic Risk - the risk associated with following a particular business strategy in a specific industry at a specific time.
  • Supplier Risk also referred to as (Supplier) Performance risk - the risk that suppliers fail to perform to expected or contracted standard. Meaning suppliers are unable to deliver on their commitments to you (unable to perform on time, on budget or on required quality and quantity). This could negatively impact the entire supply chain and may necessitate the sourcing of alternative suppliers (which could mean more costs, further delays etc).
  • Tax Risk - the risk that new taxes or higher taxes can impact on the business.
  • Technology Risk - the risk that technology becomes obsolete, causes loss or corruption of data or causes a loss in productivity or time through systems and equipment not being in working order.  
  • Technology Security Risks - such as software and/or hardware failure, cyber-attacks and malware. Research by IBM in 2018 indicated that the average cost of a data breach in South Africa was R36.5 million (although this number could have been influenced the number of participants willing to disclose actual breaches and losses).

The risks listed above do not form a complete listing of all types of business risk. It should be noted that some risks may be clustered or classified as sub-categories of others - such as liquidity risk falling under financial risk. It is also important to understand that not all business risks are due to factors external to the business. Risks could impact the entity from the outside (inflation or legislation) as well as from inside (process risk, operational risk).


Potential Impact of Business Risks


The impact of business risks can be felt across a wide area:



  • External:
    • On the Customers of any given business entity,
    • On the Environment (in the event of spillage or environmental pollution),
    • On the Community (loss of job opportunities, forced relocation e.g. Chernobyl),
    • On the State (loss of taxes).
  • Internal:
    • On the business itself e.g. efficiency of business operations or operational procedures which have to be amended to adjust for compliance requirements, 
    • On the shareholders and investors (lower profits and higher risk),
    • On the management and employees (lower profitability, less bonus and smaller increases if any) 
    • On suppliers (slow payment or loss of market share).
Risk of Climate Change
Fig 10 - The risk of Climate Change will impact many businesses in years to come (Pic credit Matthew henry burst.shopify.com)

The impact may vary significantly from one risk to the next, but could include any or a combination of the following:
  • Loss of customers or business opportunities,
  • Organised boycotts, 
  • Reputational damages,
  • Financial damage - e.g. catastrophic losses of stock, business assets or infrastructure after a natural disaster or public protest,
  • Failure to grow and thrive - the business might not be able to achieve optimal growth,
  • Delays, Stock-outages resulting in lost sales, or 
  • Increases in working capital requirements because the business is now forced to incur more costs due to higher stock-keeping as result of unreliable delivery patterns,
  • Additional costs incurred to:
    • put additional security measures in place (such as video monitoring, vehicle tracking, incident response teams),
    • Increase insurance cover (to the extent that the risks are insurable),
    • employ additional or expert level staff e.g. Risk and Compliance Officer, IT security, Quality Control,
    • Occupational Health & Safety systems, signage, equipment, training,
    • Source substitute suppliers if original suppliers fail,
  • Financial losses,
  • Business closure, 
  • Business disruption, low(er) productivity and lost efficiencies,
  • Lawsuits, court cases and fines imposed by the Government or courts,
  • Loss of operating licenses or permits,


Conclusion

This post presented an introductory overview on the topic of business risks. Following posts will look at:
  • Measuring risks
  • Managing risks
  • International vs South African perspectives of Bussiness Risk
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For more information, visit our website on www.cogniplex.co.za

All original artworks remain the property of their respective owners. Banner Firefighters training simulation - original photo courtesy of www.needpix.com 



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UNDERSTANDING BUSINESS RISK - AN INTRODUCTION

In this introductory blog post, we will delve into the topic of business risks - a topic which perhaps not as close to the hearts of m...