Business risk

Before a company borrows a single rupee, it already has a risk profile. That profile comes from what the business does.

Some businesses sell things people buy in good times and bad — food, soap, electricity. Their sales barely move across a cycle. Others sell things people postpone the moment money is tight — a new car, a factory machine, an office fit-out. Their sales swing hard.

Layer on top of that how the costs behave. A business whose costs are mostly fixed — a plant that has to be staffed and maintained whether it runs at 90% or 40% — amplifies every swing in sales into a much bigger swing in profit. A business whose costs move with volume absorbs the shock.

Sales volatility and operating leverage: those two together are business risk.

The workbook's comparison is an auto manufacturer against a retail food company.

The auto manufacturer carries high operating costs. Its earnings and sales fluctuate substantially over the business cycle, so its business risk is high. The food retailer's customers keep buying through a downturn and much of its cost base flexes with volume, so its income flows are steady.

The mechanism is operating leverage. Suppose fixed costs are Rs 400 crore and the contribution margin is 40%:

Sales Rs 1,500 cr →  contribution 600  −  fixed 400  =  EBIT 200
Sales Rs 1,200 cr →  contribution 480  −  fixed 400  =  EBIT  80

A 20% fall in sales produced a 60% fall in operating profit. Nothing was mismanaged; the cost structure did that. Now cut fixed costs to Rs 150 crore and repeat: EBIT falls from Rs 450 crore to Rs 330 crore — a 27% fall on the same 20% sales decline.

Same demand shock, very different damage, because of where the costs sit.

This matters for an alternative-investments paper because business risk is exactly what a private equity or venture fund is buying. There is no daily price to hide behind, and a growth-stage company with one product and a heavy cost base is a concentrated bet on its own operating leverage.

A Category II AIF is choosing between two unlisted companies, each seeking Rs 60 crore and each projecting Rs 1,000 crore of revenue.

Now apply a cyclical downturn — revenue down 25% for both:

Alpha:  contribution 337.5 − 300 = EBIT   37.5 cr   (down 75%)
Bharat: contribution 165.0 − 100 = EBIT   65.0 cr   (down 46%)

And a good year, revenue up 25%:

Alpha:  contribution 562.5 − 300 = EBIT  262.5 cr   (up 75%)
Bharat: contribution 275.0 − 100 = EBIT  175.0 cr   (up 46%)

Alpha's operating profit swings three times as hard as its revenue; Bharat's swings less than twice. On a Rs 60 crore ticket held through a five-year fund life that is the difference between a comfortable exit and a rescue round — and neither company has borrowed anything yet.

Chapter 1, section 1.4.3, introduces business risk as the first of the named types of risk, with the auto-manufacturer-versus-food-retailer illustration. The examinable content is the definition and its two drivers — sales volatility and operating leverage — and, almost always in the same question set, the contrast with financial-risk, which is the risk added by how the firm is funded rather than what it does.

• Business risk and financial-risk are different things. Business risk comes from operations; financial risk comes from debt. A debt-free company has zero financial risk and can still have very high business risk.
• Operating leverage is not financial leverage. The first is fixed costs; the second is fixed interest. The workbook uses "leverage" for both, so read which one the question means.
• High business risk is not the same as a bad business. Cyclicals earn well at the top of the cycle. It is variability, not inferiority.
• It is not measured by beta. Beta measures how a share co-moves with the market; business risk is a statement about the firm's own income flows, and applies just as much to an unlisted company with no share price at all.
• Sales volatility alone is not enough. A volatile business with an almost entirely variable cost base carries much less business risk than the sales figures suggest.
• Business risk is largely diversifiable across a portfolio of companies — which is precisely why a private equity fund holds ten investments and not one.