Financial risk and business risk: an overview
Financial risk and business risk are two different types of warning signs that investors need to consider when making investment decisions. Financial risk refers to a company’s ability to manage debt and leverage, while business risk refers to a company’s ability to generate enough revenue to cover operating costs.
An alternative way of looking at the difference is to consider financial risk as the risk that a company will not be able to honour debt payments and business risk as the risk that the company will not be able to operate profitably.
A company’s financial risk relates to the use of debt and debt financing rather than the operational risk of making the company a profitable enterprise.
Financial risk concerns a company’s ability to generate sufficient cash flow to pay interest on loans or meet other debt obligations. A company with a relatively high level of leverage is subject to higher financial risk, as it is more likely to default on its financial obligations and become insolvent.
Factors that can influence a company’s financial risk include changes in interest rates and the overall percentage of debt financing. Companies with a higher equity ratio are better able to manage their debt burden. One of the main financial risk metrics that analysts and investors use to assess the financial health of a company is the leverage ratio, which measures the relative proportion of debt and equity financing.
Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity
Foreign exchange risk is part of the overall financial risk for companies with significant foreign assets.
Business risk refers to the fundamental profitability of a company, i.e. its ability to generate sufficient sales and revenues to cover operating costs and make a profit. While financial risk refers to financing costs, business risk refers to all other expenses a company must incur to remain operational. These expenses include salaries, production costs, building rents, and administration and office costs.
Business risk is often divided into systematic and non-systematic risk. Systematic risk refers to the general level of risk associated with any business, the basic risk arising from fluctuations in economic, political and market conditions. Systematic risk is an inherent business risk over which companies generally have little control, apart from their ability to anticipate and respond to changing conditions.
Non-systematic risk, on the other hand, refers to risks associated with a company’s specific activity. A company can reduce its unsystematic risk by making sound management decisions regarding costs, expenses, investments and marketing. Operating leverage and free cash flow are indices used by investors to assess the operating efficiency and management of a company’s financial resources.