Question

Distinguish and explain the differences between business and financial risk and provide an example from a publicly traded company. Use specific examples and citations to support your assertion for business or financial risk. Be sure to cite your source(s).

Answer 1

Business risk, in simple terms means the risk that arises out of the operations of a business. It is a question whether a company will be able to make sufficient sales and profit or not. On the other hand, financial risk refers to the company's ability to manage its debt and financial leverage. Business risk can be viewed as as an organisation's inability to function as a profitable enterprise whereas financial risk is the chances of making default in paying off the debt capital.

For example, JP Morgan Chase that provides financial and investment banking services has a Total Debt to Total Capital Ratio as 68.35 meaning 68% of the total capital is debt financed, out of which around 37% is long term debt (in the form of long term loans and debentures). The company suffers from financial risk because it has allowed debt to finance its capital. Financial risk is directly proportional to the amount of debt in capital structure. The operating expenses of the company in 2017 amounted to $64,000,000. If the company will not be able to make required sales to cover the operating expenses required for smooth running of the business, then it is termed as Business Risk.

Business risk is inevitable and unavoidable. It will be there as long as a company operates. It has to accept the presence of a business risk if a firm wants to function smoothly and make profits. Whereas financial risk is avoidable to some extent by not allowing debt to take up a large space in the capital structure. Increasing equity capital will reduce the financial risk.

Business risk can be measured by analysing and comparing the Earnings (EBIT) of the company and also by keeping a check on the operational expenses and cutting them down, wherever possible. Financial health of a business is best measured by analysing the debt-asset ratio, debt-total capital ratio and financial leverage multiplier.

References:

https://www.wallstreetmojo.com/business-risk-vs-financial-risk/

https://www.marketwatch.com/investing/stock/jpm/profile

https://www.nasdaq.com/symbol/jpm/financials?query=income-statement