Financial Risk vs. Business Risk: Understanding the Difference


Financial Risk vs. Business Risk: Overview

Financial risk and business risk are two different types of warning signs that investors should look out for when considering investing. Financial risk refers to the ability of a company to manage its debt and financial leverage, while business risk refers to the ability of the company to generate sufficient income to cover its operating expenses.

An alternative way of looking at the difference is to view financial risk as the risk that a business may default on its debt payments and business risk as the risk that the business may not be able to function as a profitable business.

Key takeaways

  • Financial risk relates to how a company uses its financial leverage and manages its debt load.
  • Business risk relates to whether a business can generate enough sales and income to cover its expenses and make a profit.
  • With financial risk, there is concern that a business may default on its debt payments.
  • With business risk, the concern is that the business may not function as a profitable business.

Financial risk

The financial risk of a company is related to the company’s use of financial leverage and debt financing, rather than the operational risk of making the company profitable.

Financial risk refers to the ability of a company to generate sufficient cash flow to be able to make interest payments on financing or meet other obligations related to debt. A company with a relatively higher level of debt financing carries a higher level of financial risk, as there is a greater possibility that the company will not be able to meet its financial obligations and become insolvent.

Some of the factors that can affect a company’s financial risk are changes in interest rates and the overall percentage of its debt financing. Companies with larger amounts of equity financing are in a better position to handle their debt burden. One of the main financial risk ratios that analysts and investors consider to determine the financial strength of a company is the debt / equity ratio, which measures the relative percentage of debt and equity financing.

Debt / equity ratio = total liabilities / stockholders’ equity

Foreign currency exchange rate risk is part of the overall financial risk for companies that conduct a substantial amount of business in foreign countries.

Business risk

Business risk refers to the basic viability of a business – the question of whether a business will be able to make enough sales and generate enough revenue to cover its operating expenses and make a profit. While financial risk refers to financing costs, business risk refers to all the other expenses that a company must cover to remain operational and in operation. These expenses include salaries, production costs, facility rental, and office and administrative expenses.

A company’s level of business risk is influenced by factors such as cost of goods, profit margins, competition, and the general level of demand for the products or services it sells.

Special Considerations

Business risk is often classified 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 over which companies often have little control, other than their ability to anticipate and react to changing conditions.

Unsystematic risk, however, refers to risks related to the specific business a company is engaged in. 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 evaluate the operating efficiency and management of a company’s financial resources.

www.investopedia.com

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Mark Holland

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