Risky business decisions are a concern for investors, investment firms and business managers. This makes it necessary for economists to define and measure risk in detail. Without well-defined standards of risk, it would become very difficult for investors, analysts and others to accurately determine how risky a company's business practices are. A company's total risk, which is a measure of how volatile the firm's income is compared to its equity, is divided into two sections: business risk and financial risk.
TL;DR (Too Long; Didn't Read)
Business risk refers to the risk that a company faces in regard to a return on its assets, while financial risk refers to the risk that a company's financial decisions will affect its returns. While they are obviously related concepts, there's a small but meaningful difference between business risk and financial risk.
Defining Business Risk
Business risk reflects the uncertainty of the company's return on assets. It is calculated in one of two ways: You can calculate the business risk as the company's net income divided by the its total investment, or as the company's return to investors divided by the its total assets. Regardless of the method you choose, the result measures the company's overall risk of doing business. The Standard and Poor's investment research firm says that two businesses with identical financial statistics may receive different S&P ratings if their business circumstances are different based on the differing amount of business risk that the companies might have.
Factors In Business Risk
Standard and Poor's figures business risk by taking into account factors such as the riskiness of the industry that a company operates in, the country where it is based, the company's competitive position and how it compares to its rivals. Factors than affect business risk may also include variations in demand, sales price and costs, the rate of developing new products, the freedom to adjust prices as costs rise and a company's operating costs. The more that any of these aspects affect the company's income, the more they affect its overall business risk.
Defining Financial Risk
Financial risk is categorized as being separate from the regular risk of a business: It refers to how much the firm's returns will be affected by its financing decisions. If a company assumes some debt to finance an expansion, it will have to spend additional money to pay the debt down. This can make its returns more volatile and less certain over the long term. If the company can't pay off the debt then it could face bankruptcy or other legal troubles, which would put it at very high risk.
Financial Risk Management
The factors that affect financial risk include a company's accounting practices, its financial management, the management's tolerance for risk;,whether the company's cash flow is adequate, whether its assets are protected and its short-term liquidity. Two major elements in financial risk are uncertainty about what will happen and the company's exposure to risk; if things go wrong then the company suffers. It is often hard to measure financial risk because managers and investors may not realize how uncertain or how exposed a company is.
Risk and the S&P Matrix
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 the ratio of debt to earnings) as one axis and business risk as the other to arrive at a total risk rating. This matrix may not cover exceptional events, however, including the effects of major litigation, a large acquisition or a liquidity crisis on total business risk. As a result, even the well-known S&P matrix may not accurately calculate total risk in all situations.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com