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Financial Risk Essay

Business risk refers to the risk that a company does not have adequate cash flow to meet the company’s day-to-day expenses. It also indicates company has the risk of making low profits. [6] Besides that, it could be due to the company’s business nature and the riskiness inherent in the company’s operations if the company did not use debt financing. This is the risk that a business will experience a period of poor earnings or even losses. [5] Financial risk is the risk that a company will not have enough cash to meet its financial obligations.

[7]This indicates the difficulties of company to repay its debts and interests and the additional risk placed on the common stockholders of using debt financing. Thus, business may go into liquidation. Financial risk can be seen from other factors when the company could not pay its debt on the due date and could not repay to payables. Ordinary shareholders will probably expect higher return from their shares to compensate for a higher financial risk. [2]

The assets of a business must be financed somehow, and when a business is growing, the additional assets must be financed by additional capital. Nevertheless, the higher the debt, the higher

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the financial risk. In order to assess business risk, we may use the ratio analysis to find out. If there is a high percentage of operating gearing, then the company is exposed to a relatively high degree of business risk. Operating gearing is the extent to which fixed costs are used in a company’s operations.

It measures the relationship between contribution and profit before interest and tax. [2] If the fixed costs are high, even a small decrease in sales can lead to a significant decline in return of equity. So, other factors held constant, the higher a company’s fixed costs, the greater its business risk. Business risk can be assessing from the foreign risk exposure. If the company generates a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations.

This could be happen in both retailing and manufacturing company which selling and buying material from or to overseas. It would reflect the company’s profit. In addition, can assess business through survey and observe the company’s management and staff at all level to know the status of the company. Business risk assessment survey may conduct to collect more risk information from the managers and staffs. Same as business risk, financial risk can be assessing through ratio analysis, but through different gearing ratio which is the financial gearing and interest cover ratio.

Financial gearing measures the relationship between shareholders’ capital plus reserves’ and prior charge capital or borrowings or both. [1] If the company’s financial gearing ratio is less than its neutrality level of 50%, it is a low geared company. Otherwise, it is a high geared company. While the interest cover ratio measures financial risk in terms of profit rather than in terms of capital value. Generally, the interest cover is considered low if it is less than three times, indicating the profitability is too low to cover its interest.

However, the interest cover of more than seven times is considered safe. Other than ratio analysis, financial risk can be assessing through the company’s receivable collection period and payables’ payment period. Both of these periods should set at a reasonable period. The receivables collection period could not agreed in a long period, company should collect its debt as soon as possible. Thus, company will have enough cash to make payment to the payables. If the company could not collect its debt sufficiently, company may not able to make payments as company does not have sufficient cash.

For late payment, payables could take legal action towards company. To obtain more cash, company will need to borrow from external parties, which indicates the gearing of the company will be increased. Thus, company need to pay interest on the borrowing which incurred more expenses. So, company’s financial risk will be increased. Similar with business risk, financial risk can assess through the financial risk assessment. This would help to understand more about the company financial status. Moreover, these surveys could ensure company has an acceptable low level of financial risk.

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