Difference Between Business Risk and Financial Risk

Edited by Diffzy | Updated on: April 06, 2022

       

Difference Between Business Risk and Financial Risk Difference Between Business Risk and Financial Risk

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Introduction

The chance of loss or danger is referred to as risk. The company's finance department tries to prepare such a capital structure that attracts less risk and cost, and at a bare minimum, the present managerial control is diluted. According to the risk principle, there are two types of risk: business risk and financial risk. The first is a risk associated with the entity's operation, while the second is associated with loan money.

Regardless of its size, nature, or structure, every firm faces risk. There is no profit if there is no danger; hence the more considerable the risk, the better the possibilities of making a profit. While there is no way to prevent business risk, there is a way to avoid financial risk. We have summarised the significant distinctions between business risk and financial risk in this post, taking into account numerous aspects.

Before investing any money, an investor must understand the company and financial risk. Business risk is defined as the uncertainty about whether or not a firm will be able to create enough income to keep the business afloat. On the other hand, financial risk is concerned with the company's use of debt. If a firm cannot pay its debts, it may become insolvent.

Financial risk and business risk are two warning indications that investors should look into before deciding to invest. Financial risk relates to a company's capacity to manage debt and leverage, whereas business risk refers to the company's ability to produce enough income to pay operating costs. In addition, financial risk refers to the possibility that a corporation may default on its debt commitments. In contrast, business risk refers to the possibility that the company would fail to operate as a viable business.

Business Risk vs. Financial Risk

The most significant distinction between business risk and financial risk is that financial risk is concerned with paying financial commitments to avoid bankruptcy. On the other hand, business risk is the danger of the company's inability to run as a viable venture. Financial risk emerges due to changes in financial assets, currency rates, and other factors. Likewise, changes in market conditions, client demand, and other factors contribute to business risk.

To prevent financial danger, a corporation must pay its interest payments or other types of debt. Therefore, this risk will be eliminated unless you do not utilize any loan. On the other hand, business risk cannot be eliminated because it is dependent on the money required to keep a company viable.

Business risk is defined as the possibility that the firm's owner(s) will be unable to operate the company. Therefore, it's a risk related to operations and whether or not the firm will be able to generate a profit.

On the other hand, financial risk is the possibility of not being able to repay a loan. Financial risk exists when a company wishes to increase its financial leverage by allowing debt to join its capital structure. The debt you allow into your capital structure is directly proportional to your financial risk.

Difference Between Business Risk And Financial Risk in Tabular Form

The proprietors of a firm must deal with many risks to manage a business. The two most significant risks are business and financial risk, which may be distinguished from one another based on the following criteria:

Table: Business Risk vs. Financial Risk
BASIS OF DISTINCTION
BUSINESS RISK
FINANCIAL RISK
MEANING
This risk includes never being able to produce enough money to keep the business running smoothly.
It is the danger of not being capable of paying one's debts, which might lead to a company's insolvency.
CONCERN
It is concerned with the company's continued operation.
It is concerned with the company's ability to repay its creditors.
MINIMIZATION TECHNIQUES
Risk cannot be minimized in business risk.
It is possible to reduce the risk to almost zero by not employing borrowed capital.
PERIOD
Because business risk cannot be eliminated, it will always exist.
There will be no financial risk because the firm will attain a particular level of equity funding.
FUNCTION
The business risk must exist for a firm to develop.
It is said to yield superior results. As a result, the corporation is forced to take on the debts.
CLASSIFICATION
Risks like compliance, operational risk, reputation risk, financial risk, and strategic risk are all considered.
Risks Like the risk of credit, market, liquidity, exchange rate risk, etc.
REVEALED BY
Net operating income and net cash flows differ.
Differences in equity stockholders' returns.
RISK FACTOR
There is no way to reduce the risk.
There will be no risk if the company does not employ loan capital.
RISK EVALUATION
The company's earnings might be used to assess business risk.
On the other hand, the financial risk may be assessed using the debt-to-asset ratio.

What Is Business Risk?

Business Risk refers to the possibility of making a relatively low profit or even losing money due to changes in market conditions, client expectations, government restrictions, and the company environment. As a result of this risk, the company will not be able to cover its day-to-day expenditures. In nature, the risk is unavoidable.

Every company works in a particular economic climate. Both the micro and macroeconomic environments are part of the economic environment. Changes in the two environments' elements directly impact the business, posing a risk. Some of these reasons include changes in client tastes and preferences, inflation, government policy changes, natural disasters, strikes, etc. Any exposure that a business or organization has to factors that might cause it to lose money or go bankrupt is referred to as business risk. Changes in customer taste and demand, the status of the broader economy, and government laws and regulations are all potential causes of company risk. While businesses may not be able to eliminate business risk, they may take actions to reduce its effect, such as developing a strategic risk plan.

For example, a firm's CEO may make decisions that harm earnings, or the CEO may not effectively predict future events, causing the company to lose money or fail.

The following are the several types of business risk:

  • Compliance Risk: The risk arising from a change in government regulations.
  • Operational Risk: The risk that arises from mechanical failure, process failure, labor lockouts, etc.
  • Reputation Risk: The danger that arises from any deception.
  • Advertisements, lawsuits, product or service criticism, etc.
  • Financial Risk: The risk associated with borrowing money.
  • Strategic Risk: Every corporate organization has a strategy, but when that plan fails, there is a risk.

How To Identify Business Risk

1. Examine the possible causes of issues.

It's critical to identify and assess potential issue sources. Internal and external risk triggers both exist.

2. Act right now. When an issue is identified as a danger, the company's leaders should respond quickly to devise a plan of action if the risk escalates into a full-fledged worry.

3. Employees should be involved. Employees should identify and train for the risks they observe in their departments.

4. Create a list of hazards that are unique to your industry. Managers can discover potential threats by researching the industry in which their firm works.

5. Maintain a risk log. By keeping track of all the risks the firm has faced from its inception, management will be able to conduct frequent reviews of past occurrences to spot trends that can help the organization better prepare for future hazards.

What Is Financial Risk?

Financial risk is the uncertainty that arises due to the company's usage of debt finance in its capital structure. The company's capital structure might be stock capital, preference capital, debt capital, or a mix of the three. Levered businesses have a debt-financed capital structure, whereas Unlevered enterprises have a debt-free capital structure. You may be wondering how, since debt capital is one of the cheapest sources of money, it can constitute a danger for shareholders. Because, in the event of the company's dissolution, creditors take precedence over shareholders and are compensated first. Debt financing resulted in a risk that the company may not satisfy its financial obligations to its shareholders.

Furthermore, the financial risk does not end here because it is comprised of a plethora of dangers, which are as follows:

1. Market Risk: This form of risk emerges due to changes in the pricing of financial instruments. Market risk is split into two types: directional risk and non-directional risk. Directional risk is created by changes in stock prices, interest rates, and other factors. Non-directional risk, on the other hand, might be associated with volatility. In addition, companies may face compliance risks if they must follow new regulations established by the government or regulatory authority.

2. Credit risk: emerges when a person fails to fulfill their obligations to their counterparties. Credit risk is divided into two categories: sovereign risk and settlement risk. Sovereign risk is typically caused by challenging foreign exchange policies. On the other hand, settlement risk develops when one party pays but the other side fails to fulfill its promises.

3. Liquidity Risk: This risk stems from the inability to complete transactions. Asset Liquidity Risk and Funding Liquidity Risk are the two types of liquidity risk. Asset liquidity risk originates from buyers' or sellers' lack of response to sell and purchase orders.

4. Operational Risk: This risk comes from operational flaws such as mismanagement or technology breakdowns. Operational risk is divided into two categories: fraud risk and model risk. Fraud risk derives from a lack of controls, whereas model risk arises from the erroneous model application.

5. Legal Risk: Legal limits, such as litigation, create this form of financial risk. A legal risk exists whenever a corporation must incur financial losses due to legal procedures.

Key Differences Between Business Risk And Financial Risk in Points

  • The business risk is that the company will not be able to produce enough money to keep its operations running smoothly.
  • Financial risk refers to how a corporation manages its debt burden and leverages its financial leverage. The ability of a firm to earn enough sales and income to pay its expenditures and turn a profit is referred to as business risk.
  • Financial risk is concerned with a company's inability to pay its debts. This is what causes a corporation to fail.
  • In business, the risk is unavoidable. It can, however, be adequately addressed by lowering manufacturing costs.
  • It is possible to decrease financial risk by avoiding employing borrowed money in its capital structure.
  • Business risk is tied to the business's economic environment. On the other hand, financial risk is connected with the utilization of debt finance.
  • Business risk cannot be decreased. However, the financial risk may be avoided by not using borrowed capital.
  • The discrepancy between net operating income and net cash flows might reveal business risk in contrast to financial risk, which the difference in equity shareholder returns may show.
  • Business risk is triggered by changes in market circumstances, whereas changes in currency rates and assets trigger financial risk.

Conclusion

You must understand that risk and Return are inextricably linked to generating a profit. Profit cannot be increased unless there is a risk. Business risk is only concerned with a firm's money to guarantee that it stays in business.

Financial risk is the danger of being unable to pay interest or obligations, leading to bankruptcy. Whatever you do, you will not be able to escape the business risk. It may, however, be managed very well. It may, however, be exceptionally efficiently handled. Reduced production costs are an effective method to deal with it. If a corporation decides not to take any borrowed money, the financial risk is nil.

Risk and Return are inextricably linked, as you've probably heard before that if you don't take the risk, you won't make any money. Business risk is a broader phrase than financial risk, yet the financial risk is included in business risk. Business risk, unlike financial risk, cannot be avoided. The former may readily be seen in the company's EBIT, while the latter can be seen in the EPS.

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"Difference Between Business Risk and Financial Risk." Diffzy.com, 2022. Tue. 24 May. 2022. <https://www.diffzy.com/article/difference-between-business-risk-and-financial-risk-58>.



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