The risk is the possibility of loss or danger. The equity shareholders have to go through with two types of risk, i.e. Business Risk, and Financial Risk. The former is the risk related to the business of the entity while the latter is the risk due to the use of debt funds. However, if there will be no risk there will be no profit and the higher the risk; the more will be the chances of getting high returns. In this article, we have compiled the substantial differences between business risk and financial risk considering various parameters.
Definition of Business Risk
Business Risk is the probability of earning a comparatively low profit or even suffer losses because of changes in the market conditions, customer demands, government regulations and economic environment of business. Due to such risk, the firm will not generate enough profit to meet out its day to day expenses. The risk is unavoidable in nature.
Every business organisation operates in an economic environment. The economic environment includes both micro and macro environment. The changes in the factors of the two environments directly influence the business, and the risk arises. Some of those factors changes in customer tastes and preferences, inflation, change in the policies of the government, natural calamities, strikes, etc. 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 the 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 organisation works on a strategy, but due to the failure of strategy the risk arises.
Definition of Financial Risk
Financial Risk is the uncertainty arising due to the use of debt finance in the capital structure of the company. The capital structure of the company can be made up of equity capital or preference capital or debt capital or the combination of any. The firm, whose capital structure contains debt finance are known as Levered firms whereas Unlevered firms are the firms whose capital structure is debt free.
Now, you may wonder that debt capital is one of the cheapest sources of funds, then how will it become a risk for shareholders? Because at the time of winding up of the company the creditors are given priority over the shareholders, and they will be repaid first. So in this way, the risk arises that the company will not be able to fulfil the financial obligations of the shareholders due to debt financing. Moreover, 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 the fluctuations in the 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.
Key Differences between Business Risk and Financial Risk
The following are the major differences between business risk and financial risk:
- The uncertainty caused due to insufficient profits in the business due to which the firm is not able to pay out expenses in time is known as Business Risk. Financial Risk is the risk originating due to the use of debt funds by the entity.
- Business Risk can be evaluated by fluctuations in Earnings Before Interest and Tax. On the other hand, Financial Risk can be checked with the help of leverage multiplier and Debt to Asset Ratio.
- Business Risk is linked with the economic environment of business. Conversely, Financial Risk associated with the use of debt financing.
- Business Risk cannot be reduced while Financial Risk can be avoided if the debt capital is not used at all.
- Business Risk can be disclosed by the difference in net operating income and net cash flows. In contrast to Financial Risk, this can be disclosed by the difference in the return of equity shareholders.