Differences Between Business Risk and Financial Risk
Business risk of a company refers to the risk because of which the business value of the company can be affected, be it via loss of market share, or by new entrants who destroy our business or by many other forms of market competition whereas financial risk is the risk of a company where the company could not manage its finances and goes bankrupt because of liquidity risk, market risk or because it cannot pay back its interests on time which would probably trigger a fire sale.
Business is another name of the risk. But all risks are not similar. To run a business, the owners of the company have to deal with quite a lot of risks. Business and financial risk are the two most significant ones.
Business risk can be defined as the risk of whether the owner/s of the company would be able to run the business or not. We can call it a risk relating to operations and whether the company would be able to make profits or not.
Financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy., on the other hand, can be defined as the risk of not being able to pay off the debt. When a firm wants to improve its financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. by allowing the debt to enter into their capital structure, they suffer from financial risk. Financial risk is directly proportional to how much debt you allow into your capital structure.
Business Risk vs. Financial Risk Infographics
- Business risk can be defined as the risk associated with not being able to earn enough to pay off the expenses of the business. On the other hand, financial risk can be defined as the risk associated with not being able to pay off the debt the firm takes to create financial leverage.
- Business risk can never be nil. It would always be there as long as the business exists. Financial risk can be pared down to a bare minimum if the debt can be reduced, and equity can be increased in a capital structure.
- Business risk includes risks like reputational risk, operational risk, strategic risk, etc. Financial risk includes risks like credit risk, liquidity riskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases., equity risk, etc.
- Business risk can be measured by the variability in EBIT (as per situation). Financial risk can be measured by the financial leverage multiplier.
- Business risk is related to the operations of the business. Financial risk is related to the capital structure of the business.
|Basis for Comparison||Business Risk||Financial Risk|
|Meaning||Business risk is the risk of not being able to make the operations profitable so that the company can meet its expenses easily.||Financial risk is the risk of not being able to pay off the debt that the company has taken to get financial leverage.|
|What it’s all about?||Business risk is purely operational.||Financial risk is related to the payment of a debt.|
|Avoidable?||No.||Yes. If the firm doesn’t take debt, there would be no financial risk.|
|Duration||The business risk will be there as long as the company operates.||The financial risk would be there until the equity financing is increased drastically.|
|Why?||Every business wants to perpetuate and expand, and with continuation comes the risk of not being able to do it.||To generate better returns and to tap into the lure of financial leverage, the company gets into debt and takes the financial risk.|
|How to handle it?||By systemizing the process of production and operation and by minimizing the cost of production/operation.||By reducing debt financing and by increasing equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.;|
|Measurement||When there’s variability in EBIT;||We can look at the debt-asset ratio and financial leverage multiplier.|
Business risk and financial risk can happen together, but for different reasons.
Business riskBusiness RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand., as you already understood, can’t be wiped off; still business exists. But financial risk can be wiped off entirely if the business doesn’t take any debt while constructing their capital structure.
The wisest decision is to systemize the process so that the business risk can be pared down. And the capital structure also needs to be constructed in such a way that the portion of the debt is enough to enable financial leverage, but not so much to increase financial risk.
This article has been a guide to Business risk vs. Financial Risk. Here we discuss the top differences between business risk and financial risk along with infographics and comparative table. You may also have a look at the following articles for gaining further knowledge in corporate finance –