All companies face risks that can impact their operations and bottom line. Broadly, these risks fall into two main categories – business risks and financial risks. While related, these two types of risks have some key differences that business leaders need to understand.
Defining Business Risk
Business risk refers to potential threats tied directly to a company’s operations, business model, and ability to execute its strategies. This includes both risks from external forces like competition, regulations, and consumer demand shifts and risks intrinsic to the business like production issues, management capabilities, efficiency of operations, and adoption of technology.
Some examples of key business risks include:
- Demand risk – Changes in customer preferences or economic factors reducing sales
- Competition risk – Rival firms taking market share with better pricing or products
- Input risk – Disruption of production due to supply chain issues, labor problems
- Technology risk – Lagging in critical innovations and advancements
- Execution risk – Failure to implement strategies effectively
Essentially, business risk threatens the company’s capacity to generate sufficient revenue to cover its operating expenses. It is an unavoidable reality as long as the company seeks to sell products and services in the marketplace.
Defining Financial Risk
In contrast, financial risk relates specifically to how a company obtains funding and manages its capital structure, assets, and liabilities. Companies take on financial risk when they finance operations or expansions using debt, issue stock, make financial investments, or have obligations to pay fixed costs.
Types of financial risks include:
- Credit risk – Defaulting on debt obligations
- Liquidity risk – Insufficient cash flow to meet immediate needs
- Market risk – Losses from changes in asset prices or rates
- Operational risk – Financial losses tied to operational failures
The level of financial risk rises in proportion to the amount of leverage and debt a company holds compared to equity. Firms with higher fixed costs or interest expenses generally have elevated financial risks as well.
Key Differences Between Business and Financial Risks
While both business risk and financial risk can severely damage companies, analyzing them distinctly helps strategic planning. Some key differences include:
Business risks are generally unavoidable and intrinsic to operations. Companies must manage them through flexibility and adaptation.
Financial risks can be reduced through capital structure decisions – e.g. lowering debt levels and interest costs.
Nature and Causes
- Business risks originate from the viability of the core business model and operating environment.
- Financial risks arise from how assets and obligations are managed on the balance sheet.
- Business risk is linked to sales volatility and metrics like the variability in operating income or EBIT.
- Financial risk is assessed through solvency ratios like debt-to-equity and metrics like interest coverage.
- Business risks can reduce revenue, market share, and long-term competitiveness.
- Financial risks can lead to insolvency, bankruptcy, and immediate liquidity crises.
- Business risks warrant long-term strategic planning on operations.
- Financial risks require short-term liquidity management and cash flow forecasting.
Relation to Profitability
- Business risks directly reduce sales and profit margins.
- Financial risks mainly impact liquidity and balance sheet standing.
Managing Business Risks and Financial Risks
Given the threats they pose, effectively governing both business risks and financial risks is crucial for companies seeking sustainable growth. Some key principles in managing each risk category include:
Business Risk Management
- Continuously monitoring operations for early signals of emerging risks
- Maintaining flexibility to pivot strategies in response to market changes
- Investing in innovation and technology capabilities as a hedge
- Diversifying product mix, customer segments, and geographic markets
- Building robust supply chain relationships through long-term contracts
Financial Risk Management
- Establishing prudent debt levels aligned with cash flow visibility
- Maintaining adequate working capital and liquidity reserves
- Matching asset and liability maturities to minimize refinance risks
- Utilizing hedging instruments to limit exposure to interest/currency shifts
- Conducting financial scenario planning and stress testing
While some amount of risk is intrinsic to business, thoughtfully assessing and governing risks enables companies to endure unpredictable market cycles and seize opportunities as they emerge.
Implications for Strategic Planning
Because business risk and financial risk can both severely impact companies, managing them warrants an integrated strategic approach. Some key implications include:
- Incorporating risk assessments into annual planning to quantify threats in advance
- Setting risk limits tailored to the organization’s size, industry, and strategic priorities
- Identifying risk correlations and interactions to manage exposures holistically
- Establishing a risk-aware culture with clear accountability across the organization
- Investing in risk analytics dashboards providing visibility into exposures
- Maintaining contingency plans and stress testing models to prepare for turbulence
- Embedding agility in operations and strategy to adapt quickly if risks manifest
By distinguishing between business and financial risks, directors can tailor oversight and mitigation strategies to the unique drivers and consequences of each one. This leads to more targeted risk policies, preparedness, and strategic resilience regardless of market conditions.
While all companies face a multitude of risks impacting operations and finances, identifying whether threats qualify as “business risks” or “financial risks” provides clarity on appropriate responses. Business risk relates to the viability of the company’s underlying business model and operating environment. Financial risk deals with how the company finances itself and manages liabilities.
Though distinct in nature, business risk and financial risk warrant integrated governance given their potential to mutually reinforce and amplify one another during times of economic stress. By assessing each risk category distinctly while strategizing holistically, executives can best position their organization for stability and success regardless of the competitive climate.