Business Risks Articles

Diversification of Business Risks: How It Works and When It Should Be Used

Any business activity is risky and no business can escape it. Risk is the basis of making profit. Both businessmen and investors are well aware of it. Despite the fact the higher the risk, the greater the profit, most business owners try to reduce the risks or at least eliminate their unnecessary components. The basis of any effective management is to identify the potential risk and mitigate its impact.

What is the diversification of business risks?

Diversification is one of the risk reduction methods. It is commonly used when dealing with complex risks. The method mainly refers to decisions that are not taken instantly. Frequently, it takes years to implement them.

In fact, diversification is a change in the company’s activity aimed at selling new products or entering new markets. The main purpose of diversification during the process of business risks evaluation is to reduce risks without reducing profitability. At the same time, return on investment is only the second most important task.

The basic principle of diversification is quite simple. Do not risk more than your own capital affords. Putting it more clear, all diversification efforts of the company should be accomplished at the expense of self-financing.

Diversification is the most risky strategy of mitigating risks. It is carried out in the conditions of uncertainty when it is hard to estimate future expenses. In a global economy, diversification has become a necessity. It is applied by the companies that have already finished their own way of development or their markets are saturated and require new solutions.

The place of diversification among the risk reduction methods is quite important. It becomes necessary when other options do not exist.

The role of diversification in reducing risks

The basic principle of both investing and entrepreneurship is as follows: do not put all eggs in one basket.
Diversification enables the enterprise to receive additional income from other activities. Insurance and hedging are less important for the company. These are the methods of transferring risks to other people. Being quite efficient, they require additional expenses that reduce the cash flow of the company.

Who can diversify and who can’t?

Diversification of risks is perfect for enterprises that are initially engaged in different types of economic activity. Also, it works well if the enterprise has free production areas or the equipment lays idle. That’s why diversification is actually a method of the rational use of resources. Such approach to the reduction of risks is desirable for enterprises.

When it comes to the risk reduction strategy, the diversification should be considered as soon as the company starts generating a stable profit and accumulates the capital. This strategy allows the company support a necessary level of the own capital and expand simultaneously. If a risky situation occurs, it can switch to a more profitable business fully and without substantial delays.

However, diversification shouldn’t be considered as a safe method of reducing risks. Any diversification is associated with the investments that reveal new types of risks. Similarly, it should not be used when the enterprise hasn’t defined its area of activity clearly or has no knowledge how to organize a new activity. Nor should this method be used when a management system is weak or financial or labor resources are in deficit. Such spillage of capital may eventually reduce the profitability of the enterprise and reduce its production capacities.

For a non-diversified business, the main risks include but not are limited to currency, inflation, political, interest, environmental risks, etc.

For a diversified business, several new risks emerge. They are insolvency or bankruptcy risk, entrepreneurial, financial and operational risks.

Diversification of risks always entails the continuation of the enterprise’s life cycle. Accordingly, the accompanying risks that arise at a particular stage of the company’s life cycle should be considered additionally.