KEY TAKEAWAYS
- Financial risk concerns a company's ability to manage debt and financial leverage.
- Business risk is about generating enough revenue to cover operational expenses.
- A high debt/equity ratio indicates increased financial risk due to potential debt default.
- Business risk is influenced by competition, demand, and operating expenses.
- Systematic risk is external and affects all businesses; unsystematic risk is specific to a company.
Financial Risk vs. Business Risk: An Overview
Financial risk is the risk that debt and borrowing make it harder for a company to pay its loans or interest. Business risk refers to whether a company can generate enough revenue to cover its operating costs and remain profitable. Financial risk is often assessed using metrics like the debt-to-equity (D/E) ratio, while business risk includes systematic risks that affect the overall economy and unsystematic risks tied to a company’s operations or industry.
Understanding Financial Risk: Managing Debt and Leverage
A company's financial risk is related to the company's use of financial leverage and debt financing, rather than the operational risk of making the company a profitable enterprise.
Financial risk is concerned with a company's ability to generate sufficient cash flow to be able to make interest payments on financing or meet other debt-related obligations. A company with a relatively higher level of debt financing carries a higher level of financial risk since there is a greater possibility of the company not being able to meet its financial obligations and becoming insolvent.
Some of the factors that may affect a company's financial risk are interest rate changes and the overall percentage of its debt financing. Companies with greater amounts of equity financing are in a better position to handle their debt burden. One of the primary financial risk ratios that analysts and investors consider to determine a company's financial soundness is the debt/equity ratio, which measures the relative percentage of debt and equity financing.
Debt/Equity Ratio = Total Liabilities / Shareholders' Equity
Foreign currency exchange rate risk is a part of the overall financial risk for companies that do a substantial amount of business in foreign countries.
Exploring Business Risk: Sales, Revenue, and Operating Costs
Business risk refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, and office and administrative expenses.
IMPORTANT
The level of a company's business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.
Key Factors in Business Risk: Systematic vs. Unsystematic
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.
The Bottom Line
Financial risk and business risk affect companies differently. Financial risk comes from how much debt a company uses and whether it can meet its financial obligations. Business risk, on the other hand, relates to whether a company can earn enough revenue to cover its costs and stay profitable. This type of risk is shaped by expenses, profit margins, competition, and customer demand. Business risk also includes systematic and unsystematic risks.