How Companies Can Reduce Internal and External Business Risk

Business risk hinders a company's ability to provide its investors and stakeholders with expected returns. A company can reduce negative exposure to business risk by identifying internal risks and external risks.

Internal risks are faced by a company from within its organization and arise during the normal operations of the company. These risks can be forecasted with some reliability, and therefore, a company has a good chance of reducing internal business risk.

The three types of internal risk factors are human factors, technological factors and physical factors.

1. Human-factor risk can include:

• Union strikes
• Dishonesty by employees
• Ineffective management or leadership
• Failure on the part of external producers or suppliers
• Delinquency or outright failure to pay on the part of clients and customers

Personnel issues may pose operational challenges. Staff who become ill or injured and, as a result, are unable to work can decrease production. A company may need to hire or replace personnel key to the company's success. Strikes can force a business to close.

2. Technological risk includes unforeseen changes in the manufacture, delivery or distribution of a company's product or service.

For example, a technological risk that a business may face includes outdated operating systems that decrease production ability or disruptions in supplies or inventory.

3. Physical risk is the loss of or damage to the assets of a company.

A company can reduce internal risks by hedging the exposure to these three risk types. For example, companies can obtain credit insurance for their accounts receivable through commercial insurers, providing protection against customers not paying their bills. Credit insurance is usually very comprehensive and provides protection against debt default for a wide range of reasons, covering virtually every conceivable commercial or political reason for non-payment.

External risks come up due to economic events that arise from outside the corporate structure. External events that lead to external risk cannot be controlled by any one company or cannot be forecasted with a high-level of reliability. Therefore, it is hard to reduce the associated risks.

The three types of external risks include economic factors, natural factors and political factors.

1. Economic risk includes changes in market conditions.

As an example, an overall economic downturn could lead to a sudden, unexpected loss of revenue.

2. Natural risk factors include natural disasters that affect normal business operations.

An earthquake, for example, may affect the ability of a retail business to remain open for a number of days or weeks, leading to a sharp decline in overall sales for the month. It could also cause damage to the building and merchandise being sold.

3. Political risk is comprised of changes in the political environment or governmental policy that relate to financial affairs.

Increases in interest rates, changes in import/export laws, tariffs, taxes, and other regulations all may affect a business negatively.

Since external risks cannot be foreseen with accuracy, it is difficult for a company to reduce these three risk factors. Some types of credit insurance can protect a company against political events in other countries, such as war, strikes, confiscation, trade embargoes and changes in import/export regulations.

The best way to manage business risk is to maintain an adequate level of capital. Doing so allows a company to weather internal storms (updating or replacing replace faulty machinery or systems, say), to adjust or ride out unforeseen risks, and to deal with political problems. A company needs capital to carry credit insurance, for example; coverage costs are generally in the area of one-half of 1% of each dollar in sales revenue held on the accounts receivable ledger.

A company with a higher level of business risk should choose a capital structure that has a lower debt ratio to help ensure it can meet its financial obligations at all times.