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. Every return that is desired comes with some amount of risk. The risk may be high or low depending upon the returns as well as the source of capital.
Importance of quantifying financial risk
Any deviation from the desired outcome is a risk, and it is very necessary to hedge against risk as it may lead to loss of value for shareholders of the company. An analyst should properly analyze the risk before investing in a project. For ex: – While making an investment in foreign markets, analysts should take care of the economic uncertainty, market risk, liquidity risk, and any risk that can arise out of change in foreign government’s policy.
We may quantify financial risk using a degree of financial leverage (DFL), which is calculated by dividing the percentage change in net income by the percentage change in operating expense.
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.
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).
What is Financial Risk Management?
It’s the practice of managing the risk exposure of a company or a firm and balancing the capital sources in such a way so as to match the risk-taking Ability of a company. It includes managing various risks such as operational risk, credit risk, market risk, foreign exchange risk, business risk, liquidity risk, inflation risk, sector risk, etc.
Who is a financial analyst?
The one whose job is to analyze financial risk and has excellent analytical skills, Ability to communicate, Accounting or finance qualification, financial reporting, and number-crunching skills.