Business Risk vs Financial Risk
Business risk is the uncertainty associated with a firm’s projection of its future operating income. It is also defined as the risk faced by a firm’s stockholders if the firm uses no debt.
Financial risk is the risk of a firm that could not manage its finances as a result of the firm’s use of debt.
Business risk depends on a number of factors such as competition, liability exposure, and operating leverage. Conversely, financial risk depends only on the amount of debt financing.
KEY HIGHLIGHTS
- Business risk, sometimes called operating risk, is associated with day to day operations of the firm.
- Business risk is affected by sensitivity of the firm’s demand to economic conditions, market share of the firm, product diversification, operating leverage, and firm size.
- Financial risk is created by the use of fixed cost securities. The two components of financial risk are the chance that the firm will fail because of the inability to meet interest on debt, and the variability of earnings available to shareholders caused by fixed financial charges.
Business Risk is the uncertainty associated with a firm’s projected future operating income. It is affected by variability in demand for product, variability in selling price of product, variability in input prices, and amount of operating leverage used.
Risks can be quantified using leverage which consists of operating leverage and financial leverage connected as follows:
Total leverage = Operating leverage × Financial leverage
Operating leverage may be defined as the effect of fixed operating expenses on the level of net income, the rate of change of net income and the level of business risk.
Operating leverage = Gross Margin / EBIT
As the amount of fixed costs increases, leaving other variables constant, operating leverage will increase. So, the operating profits will be more sensitive to changes in demand, implying higher business risk.
Financial leverage sensitivity of the net profit to a change in operating profit.
Financial leverage = % change in EBIT / % change in net income
Financial leverage is concerned with the effect of fixed financial charges on the relationship between the change in operating profits and the change in earnings per share.
Conclusion
Business risk refers to the firm’s ability to generate sufficient revenue to cover its operational expenses, while financial risk refers to a firm’s ability to manage its debt.
Business risk relates to operational decisions. Financial risk relates to choices regarding the funding of the firm.
Business and financial risk may share certain similarities, but they require different approaches to mitigate them. As such, entrepreneurs, financial analysts, and investors need to prepare the right approaches to mitigate these risks.
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