How to Calculate Business Risk

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How to Calculate Business Risk

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What is Business Risk? 

Business risk is any risk that a business faces that can negatively impact its profitability. It can be both internal or external risks. A company needs to know what its risks are to get a risk management plan in place. 

Understand the Risks Your Business Faces

Business risk can include many different factors, such as: 

  • Your competition
  • Cost of goods
  • The economic climate
  • Government regulations
  • Consumer demand 

How to Determine Business Risk

These are some common calculations used to determine business risk: 

Solvency Ratio

This measures a business’s ability to pay its current liabilities with assets that can be converted into cash. This usually includes actual cash on hand and accounts receivable—anything else would take too long to liquidate. To be considered “solvent,” a business needs a ratio of 1.0, or $10 of cash to $1 of liabilities.

Profitability Ratio

A profit margin measures your profits from your annual sales after taxes. You want to aim for a higher ratio to handle downtrends in your particular market. It’s related to the contribution margin ratio.

The Contribution Margin Ratio

This ratio is calculated by taking your sales and subtracting variable costs:

Contribution margin/sales = 1 - variable costs/sales

Or

(Sales – variable expenses) ÷ Sales

Sales Inventory Ratio

This is a ratio that compares your business against other similar businesses in your industry. A high sales inventory ratio may indicate the possibility that you’re losing sales and that consumers are going elsewhere. If the ratio is low, your inventory may be obsolete or undesirable. Anything other than neutral can direct changes your business needs to make.

Operating Leverage Effect (OLE)

This ratio shows you how much your income will change depending on changing sales volumes. If you have more fixed assets, the impact will be higher. The formula is contribution margin ratio divided by your operating margin:

contribution margin ratio/operating margin

If the OLE is 1, that means your business has no fixed costs. So a 25% change in volume means a 25% change in income. As you add in fixed costs, it gives you more operating leverage. 

Financial Leverage Ratio

This ratio measures the amount of debt held by your business that is used to operate your business. Debt increases your business risk because you must make payments on the principal and interest no matter what. This ratio measures the impact of that debt. The formula is:

Financial Leverage = Operating Income/Net Income

For example, a ratio of 1.00 means you have no debt. 

Combined Leverage Ratio

This ratio combines OLE and your financial leverage ratio to calculate the impact of both on your company. It looks something like this:

Combined Leverage Ratio = Operating Leverage Ratio x Financial Leverage Ratio

The higher the combined ratio, the more risk your business faces. 

You can use all of the data you get from these calculations to determine the risk your business faces and what you can plan to do moving forward

Types of Business Risk

There are a few main types of business risk.

Strategic Risks

Strategic risk occurs when a business doesn’t operate according to its business model. This leads to a less effective overall strategy and the business may not reach goals. Or, your business is producing something that is no longer desired by the overall market and you must shift strategies. 

Compliance Risks

This has to do with highly regulated industries. If you aren’t aware of or adhere closely to regional, state, and federal regulations in your industry, you may become non-compliant with local laws—i.e. Staring down the barrel of compliance risk. You need to know every law and regulation in your business environment and adhere to them completely. This includes new regulatory changes. You must stay on top of them to stay compliant.

Operational Risks

This is when your business fails or falls short in its day-to-day business operations. It can mean you aren’t able to fully perform the functions of your business and can lead to both compliance and strategic risks. If you run a screen-printing business and one of your presses is out for repair for two weeks, how will that impact your bottom line?

Reputational Risks

If your business’s reputation was harmed in any way—such as being linked to food poisoning—it can severely impact your bottom line. If you’re linked to food poisoning, you’ll likely lose customers and profit from the reputational harm.

Causes of Business Risks

What causes business risks? There are three main influencing factors: natural, human, or economic. 

Natural 

Natural causes refer to flooding, earthquakes, tornadoes, and other natural disasters or events that impact a business’s ability to operate. A comprehensive commercial property insurance plan is advisable to keep your business from facing steep financial losses. 

Human

This has anything to do with your workforce. This could refer to when nurses at a hospital go on strike, or your staff is all out with the same virus. Or perhaps you’re dealing with heavy turnover and are struggling to hire fast enough to keep up with the demand of the business. 

Economic

Have the prices of material or labor risen dramatically? Have interest rates risen? Or perhaps your competition is undercutting your pricing. Whatever the reason, the financial factors are outside your control. 

Manage Business Risks with Enterprise Risk Management

As a business owner, to properly manage your business risks, you need to be aware of what they are. What are some industry-specific risks you might face? How can the business risk ratios help you look at your risk? You need to do a good deal of market research.

Once you have a good idea of the business risk you’re dealing with, we advise looking into the insurance options available to you to determine what plans can help you mitigate your risk. Here are some examples: 

  • Business interruption insurance: This covers losses incurred if your business is damaged by a covered loss and can’t operate. The policy covers payroll, rent, utilities, and even lost profits.
  • Directors and Officers Liability: This protects the officers and board members from suits brought against the company and its officers.
  • Employment practices liability: This covers against lawsuits of sexual harassment and wrongful termination.
  • Errors and Omissions insurance: Also known as professional liability insurance, this insurance protects against legal claims of malpractice or failure to perform to a professional standard.
  • Workers’ compensation: This helps cover an employee's lost wages and medical bills if they’re hurt on the job.
  • Product liability insurance: This protects both sellers and manufacturers against defects and injury as a result of product use or components.

Get Business Insurance to Mitigate Risk

If you’d like help determining the risk your business faces, we’d love to help! You can complete the form at the top of the page or give us a call at 877-907-5267.

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