Question

Briefly contrast the effect of debt finance on financial risk and operational risk.

Answer 1

Debt financing refers to the process of raising funds by the sales of debt instruments like bonds,notes etc.When a firm decides to raise funds through debt financing the firm will be subject to interest payments which are mandatory. the firm will also be required to abide by certain restrictions placed by the lenders.These restrictions are refered to as covenant.

Financial risk refers to the risk that the company will fail to meet it's debt obligations.When a company uses debt financing the firm is then legally required to make interest payments ,this might prove difficult if the firm finds it difficult to generate sufficient cash flow.As the amount of debt financing increases the level of financial risk also increases.Other factors that affect the firm's financial risk are change in interest rate and the percentage of debt in the company's finances.

Operational risk on the other hand is a type of business risk which in turn is the risk of failing to make the organization profitable.Debt financing has an effect on the financial risk aspects of the firm rather than the operational risk aspects.Operational risk is heavily effected by the actions or decisions taken by the firm's management and employees in it' day to day course of business.