What is “Business Risk”?
Business risk, which includes macroeconomic, industry and company risks, affects the earning prospects of companies across industries and their ability to generate operating cash flows. This in turn determines their capacity to fulfill debt obligations such as paying interest or repayment of principal.
Any form of lending comes with a level of default risk or the risk that a company will not be able to fulfill or honor its debt-related payments. Business risk is one of the drivers of default risk in corporate lending, along with financial risk, and an increase in business risk to a rise in economic, industry or company related risks are likely to enhance default risk. As part of the lending process, credit analysts undertake a comprehensive risk assessment in order to mitigate the risk of default.
Key Learning Points
- Macroeconomic risks include risks such as government stability, country credit rating, regulatory policies, and overall economic environment within the borrower’s country
- Industry risks refer to a set of factors specific to an industry that can adversely impact its overall performance and profits.
- Company risks relate to specific risks faced by any company, which could affect its potential profitability or solvency.
These risks relate to the stability of the incumbent government, and overall political system and environment in the borrower’s country. Further, macroeconomic risks include the credit rating of the borrower’s country, which shows the default risk associated with lending to that country or investing in its debt. Just like companies, any country with a credit rating of BB+ and lower indicates high default risk. In addition, this includes risks associated with volatility in taxes, tariffs, foreign exchange regulations, etc.
Macro-economic risks also include factors such as supply side disruption, pandemic, financial crisis, etc that could have an adverse impact on the growth and inflation outlook of an economy.
Industry risks include factors specific to an industry that can adversely impact its overall performance and profits. These include risks related to competition, technological change, growth prospects, bargaining power of buyers and suppliers, cyclicality, risk of product substitution, industry complexity and entry barriers. Furthermore, each industry has its own set of regulatory risks. For example, the oil, gas, and coal industries are more vulnerable to climate change regulations.
As part of credit analysis, analysts assess the general outlook of industries across the spectrum and underlying trends in revenues and operating profits. They also evaluate how sensitive is an industry to the business cycle.
Given below are some examples of industries and their relevant risk profile.
|High risk||Medium risk||Low risk|
|Metals and mining||Building materials||Real Estate Investment Trusts (REITs)|
|Oil and gas refining||Aerospace and defense||Railroads|
|Technology hardware and semiconductors||Media and entertainment||Logistics|
|Retail and restaurants||Transportation|
Having stated the above, it’s important to note that the risk profiles of industries change over time. For example, during the COVID-19 crisis, low or medium-risk industries such as REITs, retail and restaurants were hit as badly as any of the high-risk industries mentioned above.
Company risks relate to company-specific risk factors which could adversely impact a company’s potential profitability or solvency.
These risks cover financial risks (how much debt they have) and business risk (how the company is operated). Business risks are wide ranging and include:
- Risks associated with the borrower company’s customer base. A company with a small group of high value customers is riskier than a company with a large and varied customer base
- Product range and quality – analysts attempt to understand the risks associated with a company’s product mix and whether there is enough diversity to deal with the collapse of a major product line
- Management expertise and reliance on key individuals
- Corporate governance risk
- Operations risk
- Financial strategy risk
Given below are a few characteristics that indicate a lower risk of default to lenders and investors:
- Adoption of a quality management system
- Access to credit and equity analysts
- Transparency in discussing strategy and problems, and collaborative style of management
- Excellent track record of execution
- Rarely surprise the market
Lenders need to consider the following indicators as “red flags,” when making loans to borrowers.
|Aggressive corporate culture||Abrupt shifts in operating strategy||Complex debt structure|
|High frequency of litigation||Frequent restructurings||High use of derivatives|
|High senior management turnover||Asset sales||Aggressive in creating shareholder wealth|
|Frequent changes in accounting policies||Layoffs|