What is ‘Financial Risk’?
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
Financial risk is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company’s cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors are repaid before shareholders if the company becomes insolvent.
Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money.
Financial risk is any risk that comes from giving money to another person or entity. For example, if one lends money, one carries the financial risk that the borrower will not repay it. A venture capital firm carries the financial risk that its investments will never become profitable. Likewise, an investor who purchases an asset carries the financial risk that he/she will be unable to re-sell it.
Financial risk is the risk that a firm will be unable to meet its financial obligations. This risk is primarily a function of the relative amount of debt that the firm uses to finance its assets. A higher proportion of debt increases the likelihood that at some point the firm will be unable to make the required interest and principal payments.
Financial risk is the type of specific risk that encompasses the many types of risks related to a company’s capital structure, financing and the finance industry. These include risks involving financial transactions, such as company loans and exposure to loan default. The term is typically used to reflect an investor’s uncertainty of collecting returns and the accompanying potential for monetary loss.
Investors can use a number of financial risk ratios to assess an investment’s prospects. For example, the debt-to-capital ratio measures the proportion of debt used given the total capital structure of the company. A high proportion of debt indicates a risky investment. Another ratio, the capital expenditure ratio, divides cash flow from operations by capital expenditures to see how much money a company will have left to keep the business running after it services its debt.
Types of Financial Risk
There are many types of financial risks. The most common ones include
- Credit risk
- Market risk
- Liquidity risk
- Operational risk
- Reputational risk
- Volatility risk
- Settlement risk
- Profit risk
- Systemic risk
Credit risk is the risk businesses incur by extending credit to customers. It can also refer to the company’s own credit risk with suppliers. A business takes a financial risk when it provides financing of purchases to its customers, due to the possibility that a customer may default on payment.
A company must handle its own credit obligations by ensuring that it always has sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise, suppliers may either stop extending credit to the company, or even stop doing business with the company altogether.
Market risk involves the risk of changing conditions in the specific marketplace in which a company competes for business. One example of market risk is the increasing tendency of consumers to shop online. This aspect of market risk has presented significant challenges to traditional retail businesses. Companies that have been able to make the necessary adaptations to serve an online shopping public have thrived and seen substantial revenue growth, while companies that have been slow to adapt or made bad choices in their reaction to the changing marketplace have fallen by the wayside.
This example also relates to another element of market risk – the risk of being outmaneuvered by competitors. In an increasingly competitive global marketplace, often with narrowing profit margins, the most financially successful companies are most successful in offering a unique value proposition that makes them stand out from the crowd and gives them a solid marketplace identity.
Liquidity risk includes asset liquidity and operational funding liquidity risk. Asset liquidity refers to the relative ease with which a company can convert its assets into cash should there be a sudden, substantial need for additional cash flow. Operational funding liquidity is a reference to daily cash flow.
General or seasonal downturns in revenue can present a substantial risk if the company suddenly finds itself without enough cash on hand to pay the basic expenses necessary to continue functioning as a business. This is why cash flow management is critical to business success – and why analysts and investors look at metrics such as free cash flow when evaluating companies as an equity investment.
Operational risks refer to the various risks that can arise from a company’s ordinary business activities. The operational risk category includes lawsuits, fraud risk, personnel problems and business model risk, which is the risk that a company’s models of marketing and growth plans may prove to be inaccurate or inadequate.
Diversification of Financial Risk
Financial risk, market risk, and even inflation risk can at least partially be moderated by forms of diversification.
The returns from different assets are highly unlikely to be perfectly correlated and the correlation may sometimes be negative. For instance, an increase in the price of oil will often favour a company that produces it, but negatively impact the business of a firm such an airline whose variable costs are heavily based upon fuel. However, share prices are driven by many factors, such as the general health of the economy which will increase the correlation and reduce the benefit of diversification. If one constructs a portfolio by including a wide variety of equities, it will tend to exhibit the same risk and return characteristics as the market as a whole, which many investors see as an attractive prospect, so that index funds have been developed that invest in equities in proportion to the weighting they have in some well-known index such as the FTSE.
However, history shows that even over substantial periods of time there is a wide range of returns that an index fund may experience; so an index fund by itself is not “fully diversified”. Greater diversification can be obtained by diversifying across asset classes; for instance a portfolio of many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio outcomes.
A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However this is not an observable quantity, since the future return on any asset can never be known with complete certainty. This was a serious issue in the late-2000s recession when assets that had previously had small or even negative correlations suddenly starting moving in the same direction causing severe financial stress to market participants who had believed that their diversification would protect them against any plausible market conditions, including funds that had been explicitly set up to avoid being affected in this way.
Diversification has costs. Correlations must be identified and understood, and since they are not constant it may be necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. There is also the risk that as an investor or fund manager diversifies, their ability to monitor and understand the assets may decline leading to the possibility of losses due to poor decisions or unforeseen correlations.
Hedging of Financial Risk
Hedging is a method for reducing risk where a combination of assets are selected to offset the movements of each other. For instance, when investing in a stock it is possible to buy an option to sell that stock at a defined price at some point in the future. The combined portfolio of stock and option is now much less likely to move below a given value. As in diversification there is a cost, this time in buying the option for which there is a premium. Derivatives are used extensively to mitigate many types of risk.