Financial risk and business risk are two different types of warning signs that investors should look out for when considering an investment. Financial risk refers to a company’s ability to manage debt and financial leverage, while business risk refers to the company’s ability to generate enough revenue to cover operating costs.
Let us take a deeper look into what these two warning signs stand for, for further understanding.
A company’s financial risk relates to its use of financial leverage and debt, to make it a profitable business. Financial risk refers to a company’s ability to generate sufficient cash flow to be able to pay interest or meet other debt-related obligations. A company with a relatively higher level of debt exposure has a higher level of financial risk, as there is a greater chance that the company will not be able to meet its financial obligations and become bankrupt.
Some of the factors that can affect a company’s financial risk are changes in interest rates and the company’s percentage of total debt financing. Companies with larger amounts of equity financing are better positioned to manage their debt. One of the key financial risk ratios that analysts and investors look at to determine a company’s financial strength is the debt-to-equity ratio, which measures the relative ratio between debt and equity. Foreign exchange risk is part of the overall financial risk for companies that conduct a significant portion of their operations abroad.
Business risk refers to the fundamental viability of a business – whether a business can generate enough sales and generate enough revenue to cover operating costs and generate a profit. While financial risk deals with funding costs, business risk deals with all the other costs a business has to cover to stay up and running. These costs include wages, production costs, facility rent, office and administrative costs.
Business risk is generally classified into systematic risk and unsystematic risk.
Systematic risk refers to the overall level of risk associated with any business, with the underlying risk resulting from volatile economic, political and market conditions. Systematic risk is an inherent business risk over which companies typically have little control, beyond the ability to predict and react to changing conditions.
However, unsystematic risk refers to the risks associated with the specific activity in which a business is engaged. A company can reduce its level of unsystematic risk through good management decisions about costs, expenses, investments, and marketing. Operating leverage and free cash flow are metrics investors use to gauge a company’s performance and management of its financial resources.
Another way to look at the difference is to view financial risk as the risk that a business may default on its debt and business risk as the risk that a business will not be able to operate as a profitable business.