It is important to manage various risks for the growth of your business. Here is some information about business and financial risks to help you understand these concepts better.
Business and financial risks are two important terms which every entrepreneur and management or finance student should know about. While business risk deals more with the strategic decisions related to the smooth and profitable functioning of an organization, financial risk is related to its monetary aspects and debt.
Such a risk varies with the nature and type of investment. Excellent risk management abilities are a must for any business to succeed.
Both business and financial risks are interlinked to each other. Unfavorable business conditions may force the organization to avail loans for business expansion.
On the other hand, a huge financial risk may become detrimental to the growth of the business in the competitive business environment. Hence, in order to emerge as a successful business leader, you will have to deal with these risks in an effective manner.
Let us understand the difference between business and financial risks with the help of the following FAQs.
What are business and financial risks?
Business Risk: Business risk is the small or large risks involved in the operations of the company. Financial Risk: Financial risk is related to the structuring of the finances of an organization.
Are these risks independent of the debt that the business owes?
Business Risk: Yes Financial Risk: No
What does the variability of these risks imply?
Business Risk: It implies the uncertainty of operating income or Earning Before Interest and Taxes (EBIT). Financial Risk: It implies the uncertainty of earnings per share and the risk of insolvency due to utilization of funds from the fixed-cost sources.
Where are these risks reflected?
Business Risk: It is reflected in the variability of net operating income or net cash flows. Financial Risk: It is reflected in the variability of net cash flows of the equity owners.
How are these risks calculated?
Business Risk: It can be calculated by, dividing net income by total income, or returns to investors by total assets. Financial Risk: It can be calculated using contribution margin, operating leverage effect, financial leverage effect, and total leverage effect ratios.
How to minimize these risks?
Business Risk: It can be minimized by incorporating right strategies to combat the internal and external factors which contribute to the risk. Financial Risk: It can be minimized by maintaining an adequate cash flow, taking strategic financial decisions and undertaking hedging using financial instruments.
What are the different types of business and financial risks?
Business Risk: Strategic risk, reputational risk, operational risks, compliance risk, etc. Financial Risk: Credit risk, market risk, liquidity risk and interest rate risk.
Can these risks be controlled completely?
Business Risk: No, it cannot be controlled completely as it is inherent in the operations of the business. Financial Risk: Yes, it can be controlled completely by limiting the amount raised through debts.
What are the factors contributing to these risks?
Business Risk: The variability in demand for its products, variability in the input cost, operating leverage, variability of sales price, etc. are the pivotal factors which increase the business risk of an organization.
Entering into an entirely new business, buying stake in a company, reducing the stake in a company, introducing new products in the market, etc. are the important aspects that are related to the business risk. It is also associated with the issues regarding returns on assets of the company.
Financial Risk: Any increase in the interest rates can affect your cash flows. The ever changing foreign exchange rates also add to the financial risk of a company. Financial risks in the international business are much more than those involved in domestic business.
A lack of study of international markets can significantly increase the financial risk. Also, it increases when a certain organization decides to use debt from financial institutions for business expansion along with equity financing.
Business risk is experienced by small, medium as well as large firms and it is governed by generation of cash to run the operations of the firm on a daily basis. The main risk which all kinds of businesses face is bad economy of a nation.
If the economic growth slows down, then naturally, the business will grow at very slow pace or may even come to a standstill.
Competition with peer companies is also one of the major business risks faced by entrepreneurs. It can force businesses to lower the rates of their products which can result into reduced revenues and net profits. Competition also causes a fall in the market share of the company due to the entry of new products.
Poor management is a business risk which can be avoided by changing the board of directors. Managing business risk can be learned only after gaining sufficient experience.
When we talk about financial risk, it becomes imperative to discuss the structure of interest rates. The changes in the interest rates and foreign exchange rates can add to the financial risk. A simple example can be given to explain this fact.
If you are the owner of a finance company and have financed the projects of an overseas client, then you may face problem in recovering debts. These problems arise due to wrong interpretation of the credit worthiness of the client.