Business Risk VS Financial Risk. Financial risk refers to a company’s ability to manage its debt and financial leverage, while business risk refers to the company’s ability to generate sufficient revenue to cover its operational expenses.
- Financial risk relates to how a company uses its financial leverage and manages its debt load.
- Business risk relates to whether a company can make enough in sales and revenue to cover its expenses and turn a profit.
- With financial risk, there is a concern that a company may default on its debt payments.
- With business risk, the concern is that the company will be unable to function as a profitable enterprise.
What is Financial Risk?
Financial risk comes with the use of leverage (sometimes called gearing); it occurs when a company has a heavy reliance on debt as a funding source.
Liquidity becomes a much bigger concern for a management team that borrows, as principal and interest payments must be made to service its debt obligations.
A company that uses debt in its capital structure becomes susceptible to rising interest rates and is required to adhere to the terms of its various credit agreements.
Financial risk represents the notion that a company’s commitment to meet debt service obligations, as well as potentially onerous covenants and reporting requirements, could push the firm into an event of default.
Financial risk does not end up here as it is a myriad of risks which are given as under:
Market Risk: Risk arising due to fluctuations in financial assets.
Exchange Rate Risk: The risk arising out of the variations in the currency rates.
Credit Risk: The risk emerging because of non-payment of debt by a borrower.
Liquidity Risk: The risk originating as a result of a financial instrument is not traded quickly in the market.
What is Business Risk?
Business risk, on the other hand, is about internal and external forces that converge to create threats to a company and its management team.
These threats could emerge from:
- The external business environment, including macroeconomic forces well outside the control of management (like inflation, foreign exchange rates, or prevailing interest rates).
- Industry-specific risks, like the level of concentration in the industry, regulatory risk, barriers to entry, the threat of disruption, and other factors.
- Company or firm-level concerns, like ineffective management, reputational risk, a toxic corporate culture, and customer or supplier concentration risk.
The business risk is divided into various categories:
Compliance Risk: The risk arising due to the change in government laws.
Operational Risk: The risk originating due to machinery break down, process failure, lockouts by workers, etc.
Reputation Risk: The risk emerging as a result of any misleading advertisement, lawsuit, criticism of bad products or services, etc.
Financial Risk: The risk arising due to the use of debt capital.
Strategic Risk: Every business organization works on a strategy, but due to the failure of the strategy the risk arises.
Difference between Business Risk and Financial Risk
|Basis for Comparison
|Business risk is the risk of not being able to make the operations profitable so that the company can meet its expenses easily.
|Financial risk is the risk of not being able to pay off the debt that the company has taken to get financial leverage.
|What it’s all about?
|Business risk is purely operational.
|Financial risk is related to the payment of a debt.
|Yes. There will be no financial risk if the firm doesn’t take debt.
|The business risk will be there as long as the company operates.
|The financial risk would be there until the equity financing is increased drastically.
|Every business wants to perpetuate and expand, and with continuation comes the risk of not being able to do it.
|To generate better returns and tap into the lure of financial leverage, the company gets into debt and takes financial risk.
|How to handle it?
|By systemizing the process of production and operation and by minimizing the cost of production/operation.
|By reducing debt financing and by increasing equity financing;
|When there’s variability in EBIT;
|We can look at the debt-asset ratio and financial leverage multiplier.
Table: Business Risk VS Financial Risk
Risk and Return are closely interrelated as you have heard many times that if you do not bear the risk, you will not get any profit.
Business Risk is a comparatively bigger term than Financial Risk; even financial risk is a part of the business risk.
Financial Risk can be ignored, but Business Risk cannot be avoided.