For an investor, it is quite essential to know about the business and financial risk before investing any amount of money. The definition of Business Risk is that business risk is concerned with whether or not a company will be able to make enough money that will be responsible for the functioning of the company.
On the other hand, Financial Risk is concerned with the usage of debt in the company. If a company is not able to pay its debt, then it might go insolvent.
Business Risk vs Financial Risk
The difference between Business Risk and Financial Risk is that financial risk is all about meeting financial obligations in order to avoid bankruptcy. However, business risk is the risk of whether the company will be able to function as a profitable enterprise. Financial risk arises due to the variations in financial assets, currency rates, etc. Business risk occurs because of the changes in market conditions, requirements of the customers, etc.
A company has to pay its interest payments or other forms of debt to avoid financial risk. Not using any form of debt will also limit this risk to absolute zero.
Business risk can’t be minimized as it is based upon the revenue that is required to keep a company in business.
Comparison Table Between Business Risk and Financial Risk (in Tabular Form)
|Parameter of Comparison||Business Risk||Financial Risk|
|Meaning||It is the risk of not being able to generate sufficient revenue that is required for the proper functioning of the company.||It is the risk of not being able to pay the debts, which might result in making a company insolvent.|
|Concern||It is concerned with keeping the company operational.||It is concerned with the company paying its debts.|
|Way of Minimizing||It can’t be minimized.||It can be minimized from very little to no risk by not using the debt capital at all.|
|Duration||As business risk can’t be avoided, it will always be there.||As the company will reach a certain level of equity financing, there will be no financial risk.|
|Role||In order for a company to grow, the business risk needs to be there.||It is considered to get better returns. Therefore the company ends up taking the debts.|
What is Business Risk?
Business Risk is the risk of not being able to make enough money to keep a company operational.
This risk arises due to the changes in the conditions of the market, requirements of customers, and rules & regulations of the government.
It is unavoidable but can be handled well by focusing on the production process. The goal should be to minimize the cost that the production is eating up. This risk does not allow a company to meet its daily expenses.
Any change that occurs in the micro and macro environment affects the business directly. This is what elevates the risk. Business risk affects the business value of the company.
This risk is totally related to company operations. Business risk determines whether any profit will be made or not by the company. Every expense that a company needs to consider in order to remain operational concerns the business risk.
Some of these expenses are the salaries of the employees, the cost of production, rent of facility, etc.
What is Financial Risk?
It is the risk when a company is not able to manage its finances and becomes insolvent. This happens because of liquidity risk, market risk, etc.
To put it simply, the financial risk arises when a company is not able to pay its debts.
The risk occurs in the first place by letting the use of debt finance in the capital structure of the company. This is all done to ameliorate financial leverage. The capital structure of a company might be formed of equity capital or debt capital.
A levered firm is a term given to the companies whose capital structure is made up of debt finance. On the other hand, un-levered firms are free of any kind of debt.
Now, debt funds are a quick and cheap way to fund a company, yet they are a risk for all shareholders. When a company winds up, the creditors are the first one who gets repaid, not the shareholders. So, this is what makes it a risk for all shareholders.
Main Differences Between Business Risk and Financial Risk
- The business risk is concerned with the company not able to make enough money to keep its operation going without any hassle.
Financial risk is concerned with a company not being able to pay their debts. This is what makes a company go bankrupt.
- Business risk cannot be avoided. However, it can be taken care of properly by reducing the cost of production.
Financial risk can be avoided by not using debt funds in the capital structure of the company.
- The evaluation of business risk can be done by taking into account the earning of the company (not including taxes).
On the other hand, financial risk can be evaluated through debt to asset ratio.
- Changes in market conditions trigger business risk, while changes in currency rates and financial assets cause financial risk.
- Some of the risks that business risk includes are a strategic risk, reputation risk, etc. Financial risk includes liquidity risk, equity risk, etc.
In order to make a profit, it is crucial that you know that risk and return are closely related. Without the risk, it is impossible to boost up the profit.
Business risk is just concerned with the money that a company is making, which will ensure that it remains operational.
Financial risk is the risk of not being able to pay the interests or debts, which might result in bankruptcy.
No matter what you do, the business risk can’t be avoided. However, it can be managed very well.
An excellent way to handle it is to reduce the production cost. If a company decides not to take any debt funds, then this causes the financial risk to be absolute zero.
However, in order to have financial leverage, the company takes debt funds.
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