Risky business decisions are a concern for investors, investment firms and business managers. That makes it necessary for economists to define and measure risk in detail, so people can assess it realistically, rather than just guessing. Total risk--how volatile the firm's income is compared to its equity--is divided into two sections: business risk and financial risk, according to the Business Finance Tips website.
Business risk reflects the uncertainty of the company's return on assets. It can be calculated as the net income divided by the company's total investment or the return to investors divided by the business's total assets. It measures the overall risk of doing business. The Standard and Poor's investment-research firm says two businesses with identical financial statistics may receive different S&P ratings if their business circumstances are different.
Factors In Business Risk
Standard and Poor's says it figures business risk by estimating the riskiness of the industry; the country where the business is based; the company's competitive position; and how the company compares to its rivals. Factors than affect business risk include variations in demand, sales price and costs; the rate of developing new products; the freedom to adjust prices as costs rise; and the business's operating costs. The more these aspects affect income, the more they affect business risk.
Financial risk is separate from the regular risk of the business: It refers to how much the firm's returns will be affected by its financing decisions. If the business assumes some debt to finance an expansion, the firm will have to spend money to pay the debt down. This can make the returns more volatile and less certain. If the firm can't pay off the debt, it could face bankruptcy, which would put it at very high risk.
Financial Risk Factors
The factors that can affect financial risk, according to Standard & Poor's, include the business's accounting practices; its financial management; the management's tolerance for risk; whether the cash flow is adequate; whether the assets are protected; and the business's short-term liquidity. The "Financial Analysts Journal" says two elements in financial risk are uncertainty about what will happen and exposure; if things go wrong, the business suffers. The journal concludes that it's hard to measure financial risk because managers and investors may not realize how uncertain or how exposed they are.
Standard and Poor's rates companies based on a matrix using each company's financial risk--measured by standards such as the ratio of debt to capital or debt to earnings--as one axis and business risk as the other to arrive at a total business risk. The company says, however, that the matrix may not cover exceptional events such as the effects of major litigation, a large acquisition or a liquidity crisis on total business risk.