Nominal GDP, Real GDP and GDP Deflator
Macro risk originates from political, economic, legal, and other institutional factors in an economy, country, or region. As such, some of the factors that catalyze macro-risk include exchange rates, political instability, and gaps in legal or financial structure.
Business risks refer to the risk that the operating outcomes deviate from expectations independently of the financing method. Business risk encompasses both industry risk and company-specific risk.
Financial risk arises from a firm’s capital structure, primarily from debt and other liabilities (such as leases) that need fixed contractual payments.
It is important to note that risks have a cumulative impact. For example, both macro risk and business risk impact the operating results of a firm. Also, macro, business, and financial risks affect cash flow, net earnings, and the capacity to honor contractual payments. Lastly, financial risk umbrellas the effects of macro risk, business risk, and financial leverage.
Business risk is split into industry risks and company-specific risks.
Industry risks affect all competitors in an industry. Risk factors under industry risk impact the overall level of demand, pricing, and profitability. Components of industry risks include:
Company-specific risks are founded on the nature, scale, and maturity of a business. These risks are closely associated with the market position of a firm and its business model. Company-specific risks are classified into:
1. Competitive risk: Risk of losing market share or pricing power to other competitors. Generally, it implies a lack of competitive advantage. Competitive risk also emanates from disruption caused by new entrants who might have new technology or business models, risking a market share takeover.
Sources of competitive advantage include:
2. Product market risk: Common in startup (or pre-revenue) companies. It is the risk that a new product (or service) will fall short of expectations.
3. Execution risk: The risk that the management of a firm will not achieve the expected results. Execution risk is amplified by business risk.
4. Capital investment risk: The risk that the investment made by a firm will give sub-optimal results. Capital investment risk is common in mature businesses with stable cash flows but lacking natural investments. It also affects firms whose managements invest in high-profile ego-driven investments.
5. ESG risk: Occurs due to the potential collision of objectives of shareholders and management (governance risk). Shareholders are concerned about value maximization while management pursues growth for their reputation. Alternatively, management may resist changes to the business.
6. Operating leverage: High operating leverage positively impacts profitability and value for growing business. However, for struggling businesses, high business leverage breeds business risk.
As defined earlier, financial risk arises from a firm’s capital structure. Primarily, it arises from debt and other liabilities (such as leases) that need fixed contractual payments.
Fixed contractual payments cause greater upside and downside variations in net profit and cash flow than operating profit (financial leverage). Moreover, fixed contractual payments make firms vulnerable to a lack of financing and default risk.
Financial risk is linked to the variability of profits and cash flows. On the other hand, profits and cashflows are related to the predictability or volatility of revenues and operating cash flows, which is basically business risk. As such, it is important to restate that financial risk reflects macro and business risks’ impact.
Financial risks can be quantified using total leverage. This way, profit sensitivity is measured by examining the relationship between a change in net income and a change in revenues.
Leverage (Total leverage) consists of operating leverage and financial leverage connected as follows:
$$\text{Total leverage} = \text{Operating leverage}\times \text{Financial leverage}$$
Operating the sensitivity of operating profit (EBIT) to change in revenues:
$$\text{Operating leverage} =\frac{\text{Contribution}}{\text{EBIT}}$$
On the other hand, the financial leverage sensitivity of the net profit to a change in operating profit:
$$\text{Financial leverage} =\frac{\text{EBIT}}{\text{EBT}}$$
Note that in the financial leverage formula, net income is proxied by EBT. This is because tax rates are variable but usually a stable proportion of EBT. As such, financial leverage can be calculated as the percentage change in EBIT divided by the percentage change in EPS.
In summary, business risk can be seen as the risk of a revenue shortfall magnified by operating leverage and financial risk as the magnification of business risk through financial leverage.
Question
Which of the following is most likely a source of business risk in startup companies?
- Execution risk.
- Competitive risk.
- Product market risk.
The correct answer is C.
Product market risk is the risk that a new product will fall short of expectations. From the definition, it is a major consideration for early-stage startups since it is a substantial source of business risk.
A and B are incorrect. Competitive risk and execution risk affect early startups and mature businesses. Note, however, that product market risk is relatively prevalent in early startups.