Financial Risk vs. Business Risk: What Are They?
When considering making an investment, investors should look for both financial and business risk warning indicators. Financial risk relates to a company’s capacity to manage debt and leverage, whereas business risk refers to a company’s ability to produce enough revenue to cover its operating costs.
Financial risk is defined as the chance that a firm would fail on its debt obligations, whereas business risk is defined as the risk that the company will be unable to operate as a viable corporation.
The financial risk of a firm is tied to its use of financial leverage and debt financing, rather than the operational risk of turning it into a viable business. The capacity of a corporation to produce enough cash flow to fulfil interest payments on debt or satisfy other debt-related obligations is referred to as financial risk. A corporation with a significantly higher degree of debt financing has more financial risk since there is a larger chance of the company failing to pay its financial commitments and going bankrupt.
Interest rate fluctuations and the total amount of debt financing are two elements that might influence a company’s financial risk. Companies that have a higher level of equity funding are better able to manage their debt. The debt/equity ratio, which measures the relative amount of debt and equity financing, is one of the key financial risk factors that analysts and investors use when determining a company’s financial health.
Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity
For organizations that conduct a lot of business in other countries, foreign currency exchange rate risk is a portion of the overall financial risk.
Furthermore, the financial risk does not end here because it encompasses a wide range of issues, including the following:
|Market risk is a risk that arises from the volatility of financial assets.|
|Exchange Rate Risk: The risk that arises from fluctuations in currency rates.|
|Credit Risk: A risk that arises as a result of a borrower’s failure to repay a loan.|
|Liquidity Risk is a risk that arises when a financial instrument isn’t exchanged promptly in the market.|
Company risk refers to the possibility of making a relatively low profit or even losing money as a result of changes in market conditions, client expectations, government restrictions, and the business environment. As a result of this risk, the company will not be able to cover its day-to-day expenditures. In nature, the risk is unavoidable.
Every company works in a certain economic climate. Both the micro and macroeconomic environments are part of the economic environment. Changes in the two environments’ elements have a direct impact on the firm, posing a risk. Some of these reasons include changes in client tastes and preferences, inflation, government policy changes, natural disasters, strikes, and so on.
|The following are the several types of business risk:|
|Compliance Risk: The risk that arises as a result of a change in government regulations.|
|Operational Risk: The risk that arises as a result of mechanical failure, process failure, labour lockouts, and so on.|
|Reputation Risk: The risk that arises as a result of any deceptive advertising, a lawsuit, or criticism of poor products or services, among other things.|
|Financial Risk: The risk associated with borrowing money.|
|Strategic Risk: Every corporate organization has a strategy, but when that plan fails, there is a risk.|
Key Differences Between Business Risk and Financial Risk
The following are the major differences between business risk and financial risk:
- Business risk refers to the uncertainty that arises as a result of a company’s inability to pay out costs on time owing to a lack of profitability. Financial risk is a risk that arises from the entity’s usage of borrowed financing.
- Earnings Before Interest and Tax (EBIT) variations can be used to assess business risk. Financial risk, on the other hand, may be assessed using the leverage multiplier and the Debt to Asset Ratio.
- Business risk is tied to the business environment’s economic climate. Financial Risk is related with the usage of debt finance, on the other hand.
- If loan capital is not employed at all, business risk cannot be decreased, but financial risk can be avoided.
- The discrepancy between net operating income and net cash flows might reveal business risk. Financial risk, on the other hand, might be shown by the disparity in equity shareholder returns.
|Basis For Comparision||Business Risk||Financial Risk|
|Meaning||Business risk refers to the danger of not making enough money to cover costs.||Financial risk is the risk that arises from the capital structure’s usage of debt financing.|
|Evaluation||EBIT is a variable.||Debt to Asset Ratio and Leverage Multiplier|
|Connected with||Economic environment||Use of debt capital|
|Minimization||There is no way to reduce the risk.||There will be no danger if the company does not employ loan capital.|
|Types||Risks like as compliance, operational risk, reputation risk, financial risk, and strategic risk are all factors to consider.||Credit risk, market risk, liquidity risk, exchange rate risk, and so on are all examples of risks.|
|Disclosed by||Net operating income and net cash flows differ.||Differences in equity stockholders’ returns.|
Considerations To Be Kept In Mind
Business risk is often categorized into systematic risk and unsystematic risk. Systematic risk refers to the general level of risk associated with any business enterprise, the basic risk resulting from fluctuating economic, political, and market conditions. Systematic risk is an inherent business risk that companies usually have little control over, other than their ability to anticipate and react to changing conditions.
Unsystematic risk, however, refers to the risks related to the specific business in which a company is engaged. A company can reduce its level of unsystematic risk through good management decisions regarding costs, expenses, investments, and marketing. Operating leverage and free cash flow are metrics that investors use to assess a company’s operational efficiency and management of financial resources.