5 Types of Financial Risks That Businesses Face

When you’re starting out or expanding your business and need to take out a small business loan, there are a few things you will need to consider, aside from how much and from who to borrow. You will also need to think about your financial risk and business risk.

Financial risk is the company’s ability to manage its financial leverage and debt, or the risk that the company might default on its debt repayments. Business risk is the company’s ability to create enough revenue to cover all its operating expenses, or the risk that it won’t be able to operate as a profitable business.

1. Financial Risk

This is related to a company’s use of debt financing and leverage. It’s concerned with the business’ ability to come up with enough cash flow to be able to meet its financial obligations or make interest payments on its financing. This means that a company with higher debt financing has a higher level of financial risk.

Investors use different methods to determine the prospects of an investment. An investor may look at credit risk, currency risk, equity risk, liquidity risk, asset-backed risk, and foreign investment risk.

Just a couple of the things that might impact a business’ financial risk are the overall percentage of its debt financing and interest rate changes. A company must take into consideration its debt/equity ratio. Analysts and investors use this to determine the financial soundness of a company.

2. Debt Risk

The Debt/Equality Ratio is determined by dividing a company’s total liabilities by its stockholders’ equity. The ratio shows how much debt a company is currently using to finance its assets in relation to the value of the equity of the shareholders.

Another factor that can affect the overall financial risk for a company is the foreign currency exchange rate, if it does a lot of business in foreign countries.

3. Business Risk

The basic viability of a business is referred to as its business risk. If a company can make enough sales and bring in enough revenue to cover all of its operating costs and still turn a profit, it is considered to have low business risk. Operating expenses don’t include the costs of financing, but do include administrative expenses, rent or mortgage costs, production costs, salaries, and office expenses.

Things that can impact the business risk include profit margins, the level of demand for the services or products it sells, competition, and the cost of goods. Business risk can be impacted by per-unit price, sales volume, input costs, government regulations, competition, and the economic climate. Business risk usually comes in one of four ways: operational risk, strategic risk, compliance risk, and repetitional risk.

4. Unsystematic Risk

Business risk is broken down into unsystematic risk and systematic risk. Unsystematic risk includes the risks that are related to the actual business in which the company is engaged. The level of unsystematic risk can increase through bad management decisions over expenses, costs, marketing, and investments. Examples of unsystematic risks would be a product recall, regulatory changes that could drive down sales, or a new competitor in the same market that could pose a risk the the company’s market share.

Investors use free cash flow and operating leverage metrics to assess a company’s management of financial resources and efficiency.

5. Systematic Risk

Systematic risk, on the other hand, is something that most companies have little to no control over. These risks affect any business enterprise and include the basic risks associated from changing political, market, and economic conditions. The only way a company can control systematic risk is to anticipate and react appropriately to these changing conditions. Examples of systematic risks would be wars and recessions, inflation, and interest rate changes.