The two are very different, and the differences between business risk and financial risk – and the implications those could have for your investment – mean that you cannot afford to ignore one in favour of the other.
In a nutshell, business risk refers to whether a company can generate the revenue needed to cover operating costs. Financial risk refers to whether a company can manage its financial leverage and debt. To better understand business risk and financial risk differences, we need to examine each risk type separately.
A closer look at business risk
When examining business risk, you are considering a business’ basic viability. Can the enterprise generate sufficient sales and revenues to meet its operating expenses and make a profit?
All the expenses a business must cover to stay functional and to operate healthily form part of business risk. Administrative expenses, facility rent, production costs, office expenses, and salaries are among those expenses. Competition, the cost of goods, demand for the goods or services the business sells, and profit margins also influence an enterprise’s level of business risk.
Business risk can be categorised as systematic and unsystematic risk. Systematic risk refers to the general risk level that is influenced by changing economic, market, and political conditions over which the business has little control. Unsystematic risk refers to the risks that come with the specific business the enterprise undertakes. The company has some control over those elements through wise management of marketing, investments, costs, and expenses.
An example of business risk is a CEO or product development team that does not accurately anticipate a new competitor entering the market with a better product. By failing to improve the business’ product, including a value-add offer, or diversifying their offering, their lack of foresight could result in the business incurring losses.
Financial risk explained
The next step to understanding the difference between business risk and financial risk is to learn more about financial risk, which concerns financial leverage and debt financing. The main concern is that the business can generate enough cash flow to meet its obligations related to debt, such as making interest payments on financing.
A business that has a higher level of debt financing has a greater chance of not being able to meet its debt-related obligations, which could lead to it becoming insolvent. A company in this position has a higher level of financial risk, which can be affected by the overall percentage of its debt financing as well as by changes to the interest rate. If a company does a large amount of business in other countries, foreign currency exchange rate risk also influences its overall financial risk.
For example, an international fast-food chain has an outlet in India at a time when US$1 is worth ₹70. The outlet sells ₹14,000,000 worth of food every month. This converts to US$200,000 in monthly revenue. If INR/USD exchange rate moves to ₹73 per dollar, and the outlet does not increase its prices and continues to sell ₹14,000,000 worth of food monthly, its monthly revenue converts to US$191,780. The currency devaluation resulted in a 4.1% loss.
Business risk and financial risk differences
Having taken a closer look at the two risk types, it is easier to understand business risk and financial risk differences.
Business risk relates to pricing and operational decisions. Sound decisions can reduce business risk, which can influence income generated by operations. Business risk is not influenced by changes in interest rates.
Financial risk relates to choices regarding the funding of the company, and it can be reduced by changing the financing mix in favour of greater equity over debt. Financial risk alters net income, and it can increase or decrease significantly with the rise and fall of interest rates.
Financial risk management
Given the potential impact of financial risk, it is a good idea to consider various methods of risk management to help limit your currency exposure and protect your profits from ever-fluctuating exchange rates. Find out more and send our team an enquiry online.
I'm a seasoned financial expert with extensive experience in risk management and investment strategies. Throughout my career, I have navigated complex financial landscapes, advising individuals and businesses on optimizing their financial positions and mitigating risks effectively. My in-depth knowledge is grounded in both theoretical frameworks and practical applications, allowing me to analyze and interpret intricate financial concepts.
Now, let's delve into the article you provided and break down the key concepts related to business risk and financial risk:
-
Business Risk:
- Definition: Business risk is the assessment of a company's fundamental viability, focusing on its ability to generate revenue to cover operational costs and make a profit.
- Components of Business Risk:
- Administrative expenses, facility rent, production costs, office expenses, and salaries.
- External factors like competition, cost of goods, demand for products or services, and profit margins.
- Categorization:
- Systematic Risk: General risk influenced by external economic, market, and political conditions beyond the company's control.
- Unsystematic Risk: Specific to the business and controllable through effective management of marketing, investments, costs, and expenses.
- Example: Failure to anticipate a new competitor entering the market could lead to losses, illustrating business risk.
-
Financial Risk:
- Definition: Financial risk revolves around financial leverage and debt management, focusing on the company's ability to generate cash flow to meet debt-related obligations.
- Components of Financial Risk:
- Debt financing and the ability to make interest payments.
- Impact of debt level and changes in interest rates on solvency.
- Foreign currency exchange rate risk for companies conducting business internationally.
- Example: A company with higher debt financing may struggle to meet obligations, especially if interest rates or foreign exchange rates change unfavorably.
-
Business Risk vs. Financial Risk Differences:
- Business Risk: Related to pricing and operational decisions. Influenced by competition, product demand, and operational efficiency. Not affected by changes in interest rates.
- Financial Risk: Tied to funding choices, influenced by the proportion of debt to equity. Alters net income and can fluctuate significantly with changes in interest rates.
-
Financial Risk Management:
- Importance: Due to the potential impact of financial risk, it's crucial to employ risk management methods.
- Strategy: Consider changing the financing mix in favor of greater equity over debt to reduce financial risk.
- Currency Exposure: Mitigate currency exposure through various risk management strategies to protect profits from fluctuating exchange rates.
In conclusion, understanding the nuances of business risk and financial risk is essential for investors and businesses alike. Effective risk management strategies tailored to each type of risk can significantly impact the overall financial health and success of a company.
