Business Risk Classification

In today's business environment, risk management dominates the business agenda of many small-business leaders. Because risk represents the probability a company will suffer a loss, it can significantly and negatively affect a leader's efforts to increase the value of a company's shares, its net worth or the company's future performance. The first step in the risk management process is the classification of each business risk as a financial, operational or strategic risk based on the risk's characteristics and its origin.

The potential for a company's actual returns to vary from expected returns is business risk. The type and magnitude of risks a company must deal with depends on a company's operations. For companies operating in the mines and metals industry, resource nationalism, skills shortage and infrastructure access were the top three business risks in 2011 and 2012, according to Ernst & Young. In contrast, the top business risks for the media and entertainment industry in 2009, according to the accounting firm, included economic downturns, consumer demand shifts and new market entrants.

Financial risks include those events that can weaken business earnings or cash flow, and affect shareholder wealth, because investors may value a company by discounting a company’s projected cash flows. Financial risks refer to market risk, which include changes in equity prices, credit spreads, interest rates and commodity prices, and liquidity risk, which is the risk to retained earnings or capital due to a company’s inability to meet its current obligations without incurring significant losses. Other financial risks include credit risk, capital structure risk and company reporting risks. Credit risk refers to a company’s inability to meet its financial obligations, and capital structure risk relates to the way a company finances its operations and the proportion of debt to equity. Reporting risk pertains to the inaccuracy or untimely reporting of accounting, tax and regulatory data to stockholders and government agencies.

Operational risks relate to a company's internal activities and include process risk and innovation risk. Process risk pertains to the lack of needed resources -- employees, processes, equipment and materials -- that the company uses to produce output and the continuity of operations. Innovation risk pertains to failed performance improvement initiatives, upgrades of a business processes and the lack of balance of investments in incremental improvements of existing products, the creation of products closely related to existing products and the development of new products.

Strategic risk relates to a company's operating environment, its business activities and the company's communications with investors. Business environmental risk pertains to issues with the markets in which a company buys and sells goods and services, and government regulation and other compliance issues. Such risk also includes unfavorable swings in the supply or demand for the company's products and the competitors with whom the business competes for sales and supplies.