Financial Risk Definition
Financial risk is the inability of the firm to not being able to pay off the debt it has taken from the bank or the financial institution.
Pepsi’s Debt to Equity ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. was around 0.50x in 2009-2010; however, Pepsi’s leverage has increased over the years and is currently at 3.38x. This situation is obviously undesirable. But if a firm uses prudence to take debt, then they can keep their risk at a minimum.
Let’s say that a firm wants to reduce financial risk, and at the same time, they want to take advantage of the financial leverage debt will provide. In this case, they should go for 70% of equity and only 30% of debt in their capital structure. Of course, this is hypothetical, and after looking at all factors, the decisions related to the capital structure should be made.
One thing that a firm should remember to reduce this type of risk is to construct its capital structure by taking off too much burden from its shoulder. That means taking as much as loans as they can support themselves. If the firm goes for 60% debt and 40% equity, the financial risk for the firm would be much more than if the firm goes for 60% equity and 40% debt.
Types of financial risk
There are mainly three types of Financial Risks. Let’s look at them below –
#1 – Credit risk:
This is the most common type of financial risk. If a firm takes a loan and isn’t able to pay it off, they definitely have credit risk. Normally, firms who are about to default suffer from credit risk. The default isn’t a good idea because it can affect the reputation of the firm, and it will also affect the banks or financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. . If, in any case, the firm would like to get a loan from the bank/financial institution, it would be too hard to convince them.
#2 – Liquidity risk:
This is another type of Financial risk. When a firm isn’t able to sell an asset quickly, it is a 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. for the firm. For example, if a firm buys an asset and then in the near future it becomes obsolete, it would be pretty risky for the business. Because the business won’t be able to sell it off and also it wouldn’t be able to keep the asset.
#3 – Equity risk:
Equity Risk is the third type of Financial Risk. When the market becomes volatile, it becomes difficult for the company to value its equity stocks. The market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price. often goes down, which doesn’t seem to be good news for the firm. This volatility of the equity stock market is called the equity risk, which comes with the financial risk of the firm.
How to measure financial risk?
Financial risk can be measured by all means. The firm should look at the market and see how the firm is being valued. The valuation is very important, which offers the firm an idea of where they stand in the market. At the same time, the firm can calculate the financial leverage and the degree of financial leverageDegree Of Financial LeverageThe degree of financial leverage formula computes the change in net income caused by a change in the company's earnings before interest and taxes. It aids in determining how sensitive the company's profit is to changes in capital structure.. The firm can also use debt-equity ratio, interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt., and other financial ratios to find out its level.
This article has been a guide to what is Financial Risk. Here we discuss the types of financial risks and the ways to measure it. You may also have a look these recommended Corporate finance articles –