Level 1 CFA® Exam:
Introducing Business Risks to CFA Candidatesstar content check off when done
As businesses grow and expand, the potential for a risk to their operations and finances increases. Managing these risks is critical to the success of any business. Also, understanding the different types of risks and how to manage them is essential. Risk can be divided using different classifications. One of them distinguishes 3 types of risk that businesses face:
- macro risk,
- business risk, and
- financial risk.
Macro risk is the risk that comes from external factors that the company cannot directly control. This includes things like changes in government policies, political instability, interest rates, currency fluctuations, or economic downturns. Macro risk can have a significant impact on a business’s operations, profits, and long-term sustainability. To embrace macro risk, businesses should monitor industry developments, anticipate possible changes in the economy, and develop strategies to adjust their operations or finances in response.
Business risk is the risk associated with operating earnings which, in turn, depend on revenues. As we know, revenues are influenced by a large number of factors, such as economic and demographic factors, legal regulations, etc., hence the presence of business risk. Typically, companies operating in the same industry have a similar level of business risk.
Business risk consists of 2 components. The first is sales risk when the price or quantity of products or services is different than expected. The other component of business risk is operating risk. It depends on the ratio of fixed costs to variable costs. The higher it is, that is the greater the share of fixed costs in total costs, the greater the operating risk of a company.
Business risk is caused by internal (company’s specific) or external (industry + macro) factors.
Financial risk is the risk associated with how a company finances its operations.
As you remember, we can distinguish 2 financing sources:
- debt financing,
- equity financing.
Financial risk is affected only when the company uses debt financing. Taking on fixed obligations, such as debt and long-term leases, directly influences financial risk. Therefore, the greater the company’s fixed-cost financial obligations, the greater its financial risk (the greater the financial leverage).
The other way of financing, that is equity financing by issuing common shares or using retained earnings, does not incur fixed obligations. Thus, it does not increase financial risk.
CFA Exam: Industry Risks vs Company-Specific Risksstar content check off when done
There is also a classification that divides business risks into industry risks and company-specific risks.
Industry risks include:
- industry structure,
- competitive intensity,
- competitive dynamics within the value chain,
- long-term growth and demand outlook, and
- other industry risks.
There are many different types of company-specific risks but we will focus on:
- competitive risk,
- product-market risk,
- product and service differentiation,
- execution risk,
- capital investment risk, and
- ESG risk.
Industry Risksstar content check off when done
Industry risks are a major factor to consider when making business decisions. Understanding the risks associated with the industry is essential for companies to remain competitive and profitable.
Cyclicality is the tendency of industry to experience periods of growth and decline. Industry demand and prices can fluctuate greatly, as can the number of competitors in the market. Companies must be able to anticipate and respond to these fluctuations in order to remain competitive. Usually, cyclical companies prefer lower financial and operating leverage because it means lower risk during challenging times.
Industry structure is another risk factor to consider. It includes the number and size of competitors, the structure of the industry (i.e., concentrated or fragmented), and the type of competition. Companies must be aware of the structure of their industry and how it affects their ability to compete.
Competitive intensity is the level of competition in an industry. The higher the competitive intensity, the more difficult it is to gain a competitive advantage. Also, the lower the competitive intensity in the industry, the higher the overall profitability of the industry.
Competitive dynamics within the value chain is another risk factor to consider. This includes understanding how different players in the industry interact with each other and the power dynamics between them. Companies must be aware of how their suppliers, partners, and competitors are operating because it directly impacts the company’s profitability.
The long-term growth and demand outlook is another industry risk. Companies must be aware of the current and projected demand for the industry’s products or services to plan for the future. If the industry experiences a decline in growth or slump in demand, the competition in the industry will intensify leading to some companies leaving the market.
Finally, there are other industry risks that must be considered. These include technological advancements, changing customer preferences, government regulations, and political instability.
Companies must be aware of the potential risks associated with their industry and develop strategies to mitigate them. By understanding the risks associated with their industry, companies can make informed decisions and stay ahead of their competitors.
Company-Specific Risksstar content check off when done
Level 1 CFA Exam Takeaways: Business Risksstar content check off when done
- Macro risk is the risk that comes from external factors that the company cannot directly control.
- Business risk is the risk associated with operating earnings which, in turn, depend on revenues.
- Financial risk is the risk associated with how a company finances its operations.
- Industry risks include: cyclicality, industry structure, competitive intensity, competitive dynamics within the value chain, long-term growth and demand outlook, and other industry risks.
- Company-specific risks include: competitive risk, product-market risk, product and service differentiation, execution risk, capital investment risk, and ESG risk.
- Product-market risk is the risk that the company will fail to reach the so-called product-market fit.