Financial Risk

Lesson

Financial risk refers to the possibility that a company's cash flow will not be sufficient to meet its financial obligations. This type of risk is inherent in businesses that rely heavily on debt financing or have a high degree of operating leverage. Understanding financial risk is crucial for investors, as it can impact a company's profitability, stock price, and overall financial health.

Practice Question #1

Which of the following is an example of financial risk?

A) A company's stock price declines due to a market-wide recession.

B) A company faces increased competition in its industry.

C) A company's borrowing costs increase due to rising interest rates.

D) A company's operations are disrupted by a natural disaster.

Select an option above to see an explanation here.

A) This is an example of market risk. B) This is an example of business risk. C) This is an example of financial risk, as the company's cash flow may be insufficient to meet its increased debt obligations. D) This is an example of business risk.

Terms

Financial risk:: The risk that a company will not have enough cash flow to meet its financial obligations.
Debt financing:: Borrowing money to finance a company's operations or investments.
Operating leverage:: The proportion of fixed costs to variable costs in a company's operations.
Liquidity risk:: The risk that a company cannot convert its assets into cash quickly enough to meet its financial obligations.

Practice Question #2

Which type of risk is most closely related to a company's reliance on debt financing?

A) Market risk

B) Business risk

C) Financial risk

D) Systematic risk

Select an option above to see an explanation here.

A) Market risk is related to the overall market's performance. B) Business risk is related to a company's operations or industry. C) Financial risk is related to a company's ability to meet its financial obligations, which its reliance can impact on debt financing. D) Systematic risk affects the entire market or economy.

Do Not Confuse With

Business risk:: The risk that a company's operations or industry will face challenges, such as increased competition or changing consumer preferences.

Practice Question #3

What is the primary difference between financial risk and business risk?

A) Financial risk is related to a company's operations, while business risk is related to its industry.

B) Financial risk is related to a company's ability to meet its financial obligations, while business risk is related to its operations or industry.

C) Financial risk affects the entire market, while business risk is specific to a company.

D) Financial risk is related to a company's stock price, while business risk is related to its profitability.

Select an option above to see an explanation here.

A) This statement is incorrect, as financial risk is related to a company's financial obligations, not its operations. B) This statement accurately describes the difference between financial and business risks. C) This statement is incorrect, as financial risk is specific to a company, not the entire market. D) This statement is incorrect, as financial risk is related to a company's financial obligations, not its stock price.

Real-World Example

A company that relies heavily on debt financing to fund its operations may face financial risk if interest rates rise, increasing its borrowing costs. This could lead to reduced profitability and difficulty meeting its debt obligations, potentially resulting in financial distress or bankruptcy.