Leverage notes: Operating leverage, Financial leverage, Composite or combined leverage.
QUESTION: Differentiate between Financial risk and Business Risk?
Answer:
BUSINESS RISK: Business risk is also known as operating risk. It implies uncertainty in profits or danger of loss leading to shut down of that business. These risks may arise due to future uncertainties. Example:
- Change in demand due to changes in tastes.
- Changes in the preferences of consumers.
- Strikes and lockouts.
- Changes in government policy.
- Changes in technological factors etc.
FINANCIAL RISK: this risk is associated with the capital structure of the company. A company with no debt financing has no financial risk. The extent of financial risk depends upon the leverage of firm’s capital structure.
DIFFERENCE BETWEEN FINANCIAL RISK AND BUSINESS RISK
| BASIS OF DIFFERENCE | BUSINESS RISK | FINANCIAL RISK |
| Meaning | The risk of insufficient profit to meet out the expenses is known as business risk. | Financial risk is the risk arising due to the use of debt in the financial structure of the company. |
| Evaluation | Business risk is evaluated by the variability in the Earnings before Interest and Tax (EBIT). | Financial risk is evaluated by leverage multiplier and debt to asset ratio. |
| Connected with | Business risk is connected with the economic environment. | Financial risk is connected with the use of the debt. |
| Minimization or Prevention | Business risk cannot be minimized. | If the firm does not use debt funds, there will be no risk. |
| Types | Compliance riskOperation riskReputation riskStrategic risk | Credit RiskMarket riskLiquidity riskExchange rate risk etc. |
| Disclosed by | Business risk is disclosed by difference in not operating income and net cash flows. | Financial risk is disclosed by difference in return of equity shareholders. |
| Measured by | Business risk is measured by operating leverage. | Financial risk is measured by financial leverage. |
CONCLUSION
Risk and return are closely inter-related. If there is no risk, there is no return. Business risk is comparatively bigger term than financial risks as financial risk is a part of business risk. Financial risk can be ignored but business risk cannot be avoided.