The Difference Between Business Risk and Financial Risk

Business Risk vs Financial Risk: What's the Difference?

      Risk is understood as the chance of loss or harm. A company's finance department tries to set up a capital structure that attracts risks and costs, as well as existing management controls, diluted to a minimum.

There are two types of risk, according to the principle of risk, namely: business risk and financial risk.

The first is the risk associated with the business of the entity, while the second is the risk due to the use of debt funds.

Risk is always present in every business, regardless of its nature, size, and structure. If there is no risk, there is no profit and thus, the higher the risk, the greater the chance of earning high returns.

While business risk is unavoidable, financial risk is basically avoidable. This is the difference between business risk and financial risk taking into account various parameters.

Business Risk Definition

Business risk is the possibility of making low profits or even suffering losses, due to changes in market conditions, customer demands, government regulations and the business economic environment.

Because of this risk, the company will not generate sufficient profit to meet its daily expenses. That risk cannot be avoided.

Every business organization operates within the economic environment. The economic environment includes both the macro and micro environments. Changes in the two environmental factors can affect business, and risks can arise.

Some of the factors include: inflation, changing tastes and preferences of customers, changes in government policies, natural disasters, strikes, etc.

Business risks are divided into various categories:

- Operational Risks: these come from machine breakdowns, process failures, lockouts by workers,

- Compliance Risk: occurs because of changes in government laws.

- Financial risk : caused by the use of debt capital.

- Reputational Risk: as a result of misleading advertising, lawsuits, criticism of poor products or services, etc.

- Strategic Risk: every business organization works based on methods and strategies, but because of the failure of the strategy, risks arise.

Definition of Financial Risk

Financial risk is uncertainty that arises due to the use and financing of debt in the company's capital structure.

The capital structure of the company can consist of equity capital, preference capital, debt capital or a combination of these.

A company, whose capital structure contains debt financing is known as a leveraged firm, while an unlevered firm is a company whose capital structure is debt-free.

Debt capital is one of the cheapest sources of funds, so how is it going to be a risk to shareholders? When the company is closed, creditors are given priority over shareholders, and they will be paid off first.

So in this way, there is a risk that the company will not be able to fulfill the financial obligations of the shareholders due to debt financing.

Moreover, the financial risks do not end here, as there are many risks as given below:

1. Market risk : occurs due to fluctuations in financial assets.

2. Credit risk: this arises because the debtor is not paid off by the borrower.

3. Exchange Rate Risk : a result of variations in currency exchange rates.

4. Liquidity Risk : Derived from financial instruments that are not traded rapidly in the market.

Main Difference Between Financial Risk and Business Risk

The following are the key differences between business risk and financial risk:

- Financial risk is the risk arising from the use of debt funds by the entity.

- Business Risk.: the uncertainty caused by insufficient profits in the business because the company is unable to pay the costs on time.

- Business Risk can be evaluated by fluctuations in income before interest and taxes. However, financial risk can be investigated with a multiplier of leverage and debt-to-asset ratio.

- Business Risk is related to the business economic environment. In contrast, Financial Risk is related to the use of debt financing.

- Business Risk cannot be mitigated while Financial Risk can be avoided if debt capital is not used at all.

- Business risk can be expressed by differences in net operating income and net cash flows. In contrast to Financial Risk which can be expressed by differences in the return on shareholders equity.

Conclusion

Risk and Return are closely intertwined because you often hear that, if you don't take risks, you won't make a profit.

Business Risk is a term that is relatively larger than Financial Risk; even financial risks are part of business risks. Financial Risk is negligible, but Business Risk cannot be avoided. The former is easily reflected in EBIT whereas the latter can be shown in company EPS.