Business, Sales, Operating Risk, and Financial Risks

Risk can be defined in several ways. However, one fairly simple definition is, “risk refers to the uncertainty of a return and the potential for financial loss.” Risk can arise from both financing and operating activities and can be classified in several ways. Some examples of risks are business risk, sales risk, and operating risk.

Leverage

The term ‘leverage’ describes the use of fixed costs in the cost structure of a company. It increases the volatility of a company’s earnings and cash flows as well as the risk of lending to or owning the company. Companies that use more fixed costs relative to variable costs in their cost structures will have a greater variation in net income as their revenues fluctuate.

The greater the leverage of a company, the more the risk it has and the higher the discount rate which should be used in its valuation.

Highly leveraged companies also have a much greater chance of suffering serious losses during a downturn. Consequently, they are more prone to financial distress and bankruptcy.

Financial Risk

Financial risk is the risk associated with how a company finances its operations, i.e., whether it relies either on equity or debt financing. Financial risk analysis, therefore, takes the amount of leverage that a company has into account.

The higher the amount of leverage a company has, the higher the financial risk to its stockholders.

Business Risk

Business risk is the risk that is inherent in a company’s operations or operating earnings. It may also be considered the risk of a company’s assets when no debt is used.

Business risk reflects a company’s sales risk as well as its operating risk. Companies operating in the same line of business will generally have similar business risks.

Sales Risk

The uncertainty associated with the price and quantity of goods and services is referred to as sales risk. It is affected by the demand for a company’s product as well as the price per unit of the product.

Operating Risk

Operating risk is the risk that is attributed to a company’s operating cost structure, specifically concerning the use of fixed costs. The greater the level of a company’s fixed operating costs, relative to its variable operating costs, the greater is its operating risk.

Question

The risk that is associated with how a company finances its operations is most likely known as:

A. Operating risk

B. Financial risk

C. Sales risk

Solution

The correct answer is B.

‘Financial risk’ is the term used to describe the risk associated with how a company finances its operations.

Reading 34 LOS 34a:

Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk