Difference Between Business Risk and Financial Risk

What is Business Risk?

Business risk can be defined as the risk of the business owner being able to carry out the business. In terms of management, it can be said that there is a risk to whether the company is profitable or not.

Business risk is the risk that a firm’s reputation will be adversely affected through loss of market share, disruption of its business by new entrants, or many other forms of market competition. Financial risk, by contrast, is liquidity risk, market risk, or the risk that a company will be unable to manage its finances and go bankrupt due to a failure to repay interest on time, in which case a fire sale may occur.

The following are the categories of business risk.

  1. Compliance risk: Risk resulting from changes in government law.
  2. Reputation risk: Risk arising from misleading advertising, lawsuits, criticism of bad product or services.
  3. Financial risk: Risk arising from the use of leverage.
  4. Operational risk: Risk caused by machine failure, process failure, worker lockout.
  5. Strategic risk: Every business organization is working on a strategy, but the failure of the strategy creates risk.

What is Financial Risk?

The  financial risk of a company is related to its use of debt capital and debt financing, not the operational risk that makes it a profitable company.

Financial risk relates to an entity’s ability to generate sufficient cash flows to pay interest on its financing or other debt-related obligations. Companies with higher relative leverage face higher financial risk due to the higher likelihood of financial default or insolvency.

The factors that can affect a company’s financial risk are changes in interest rates and their overall percentage of leverage. One of the most important financial risk indicators that analysts and investors consider to determine the financial health of a company is the leverage ratio.

In addition, financial risks are not limited to these, but include the following risks.

  1. Market risk: Risk arising from changes in financial assets.
  2. Currency risk: The risk arising from fluctuations in exchange rates.
  3. Credit risk: The risk arising from the nonpayment of debt by borrowers.
  4. Liquidity risk: The risk arising from the failure of financial instruments to trade quickly in the market.

Difference Between Business Risk and Financial Risk

Business risk and financial risk can occur simultaneously, but for different reasons. Financial risk relates to how a company uses financial leverage and manages its debt burden. Business risk is about whether a company can generate enough revenue and revenue to cover its expenses and make a profit.

As we all know, business risk cannot be eliminated. However, financial risk can be completely eliminated if the company does not take on  debt when building its capital structure.

The smartest decision is to organize your processes to reduce business risk. Also, the capital structure must be such that the debt ratio is sufficient to allow for financial leverage, but not to the extent that it increases financial risk.

Comparison Between Business Risk and Financial Risk

Parameter of ComparisonBusiness RiskFinancial Risk
DefinitionBusiness risk is that a company cannot make its operations profitable so that it can easily cover its costs.Financial risk is that an entity will not be able to repay its debts in order to obtain financial leverage.
DurationBusiness risk exists as long as the company is in operation.Financial risk will exist until there is a significant increase in equity financing.
MeasurementVariability is EBIT.Leverage Multiplier or Debt to asset ratio.
HandlingSystematize production and operation processes to minimize production costs.By reducing leverage and increasing equity funding.