Financial risk

Financial risk is the risk which an entity or a venture has from having to make high fixed payments either to debt holder(s) or on bank loan(s) from their capital. 

We may quantify financial risk using degree of financial leverage (DFL) which is calculated by dividing the percentage change in net income by the percentage change in operating expense.

Source: Tavaga Research

The more debt in the capital structure or higher the financial leverage, the higher the DFL will be.

The higher the DFL, the more difficult it is for companies to make fixed payments such as loan interest payments.

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As enterprises are legally bound to service debt holders and bank loans with regular payments, companies with a high debt proportion, in their capital (payment) structure, run a higher financial risk than those financed by equity holders and retained earnings (which don’t require regular repayments or interest payments).