Question

Explain the concept of financial risk and its role in asset valuation and financial decision making

Answer 1

Financial risk refers to risk related to financial transactions like loan, dividend payments, cash inflows to a company etc. There are different kinds of financial risk like counterparty credit risk, default risk, liquidity risk, currency risk etc.

Financial risk is relevant to both individual and companies. At an individual level we have financial risk related to default on loan payments which we may have taken from bank, reduction in price of different company shares we possess, no dividend payment over the years etc.

At a company level financial risk is applicable at large volumes of financial transactions. It may happen that company does not have enough cash to cater to short term creditors, therefore, company faces liquidity risk. If company does not receives loan payments back from its debtors it is facing credit risk. Company may default on loan payments towards the bank because of paucity of short term funds. So company in this case face both default risk and liquidity risk.

In asset valuation like valuation of company it is very important to assess probability of cash inflows which is expected in future. While estimating probability, all the risk factors must be taken into account. These risk factors pertains to various components of financial risk like liquidity risk, credit risk etc.Similarly financial decision making like capital budgeting decisions, decisions to take up a project involving heavy funding etc. demands detailed analysis of applicable financial risk which may arise because of external factors like incumbent government policies, volatility in market, high operating cost, funding issues etc. Most financial analysts capture applicable financial risk to the firm using increased discount factors. They would try to estimate the probability of cash inflows taking into account all possible external factors which could lead to different kinds of financial risks.