What is 'Financial Risk'

Financial risk is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company's cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors are repaid before shareholders if the company becomes insolvent.

Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money.

BREAKING DOWN 'Financial Risk'

Financial risk is the type of specific risk that encompasses the many types of risks related to a company's capital structure, financing and the finance industry. These include risks involving financial transactions, such as company loans and exposure to loan default. The term is typically used to reflect an investor's uncertainty of collecting returns and the accompanying potential for monetary loss.

Investors can use a number of financial risk ratios to assess an investment's prospects. For example, the debt-to-capital ratio measures the proportion of debt used given the total capital structure of the company. A high proportion of debt indicates a risky investment. Another ratio, the capital expenditure ratio, divides cash flow from operations by capital expenditures to see how much money a company will have left to keep the business running after it services its debt.

Types of Financial Risks

There are many types of financial risks. The most common ones include credit risk, liquidity risk, asset-backed risk, foreign investment risk, equity risk and currency risk.

Credit risk, also referred to as default risk, is the type of risk associated with people who borrow money and become unable to pay for the money they borrowed. As a result, they go into default. Investors affected by credit risk suffer from decreased income from loan payments, as well as lost principal and interest, or they deal with a rise in costs for collection.

Several types of financial risk are tied to market volatility. Liquidity risk involves securities and assets that cannot be purchased or sold quickly enough to cut losses in a volatile market. Equity risk covers the risk involved in the volatile price changes of shares of stock. Asset-backed risk is the risk that asset-backed securities may become volatile if the underlying securities also change in value. The risks under asset-backed risk include prepayment risk and interest rate risk, both of which may also accompany other types of risk.

Investors holding foreign currencies are exposed to currency risk because different factors, such as interest rate changes and monetary policy changes, can alter the value of the asset that investors are holding. Meanwhile, changes in prices because of market differences, political changes, natural calamities, diplomatic changes or economic conflicts may cause volatile foreign investment conditions that may expose businesses and individuals to foreign investment risk.

An Example of Financial Risk and Leveraged Buyouts

Toys "R" Us announced in September 2017 that it had voluntarily filed for Chapter 11 bankruptcy. In a statement released alongside the announcement, the company's chairman and CEO said the firm was working with debtholders and other creditors to restructure the $5 billion of long-term debt on Toys "R" Us' balance sheet. The firm also announced that it had received a commitment for more than $3 billion in debtor-in-possession financing from a JP Morgan-led bank syndicate, existing Toys "R" Us lenders and others — all of whom were clearly subject to financial risk, alongside Toys "R" Us shareholders. 

Much of this financial risk reportedly stemmed from a $6.6 billion leveraged buyout of Toys "R" Us by mammoth investment firms Bain Capital, KKR & Co. and Vornado Realty Trust in 2005. In March 2018 after a disappointing holiday season, Toys "R" Us announced that it would be liquidating all of its 735 U.S. locations in order to offset the strain of dwindling revenue and cash amid looming financial obligations. Reports at the time also noted that Toys "R" Us was having difficulty selling many of its U.S. stores, an example of the liquidity risk that can be associated with selling real estate. Many commentators have pointed to the struggles of Toys "R" Us as proof of the immense financial risk associated with debt-heavy buyouts and capital structures, which inherently heighten risk for creditors and investors.

RELATED TERMS
  1. Market Risk

    Market risk is the possibility of an investor experiencing losses ...
  2. Business Risk

    Business risk is the possibility a company will have lower than ...
  3. Accepting Risk

    Accepting risk occurs when a business acknowledges that the potential ...
  4. Operational Risk

    Operational risk summarizes the risks a company undertakes when ...
  5. Specific Risk

    Specific risk is a risk that affects a minimal number of assets, ...
  6. Credit Risk

    Credit risk is the chance of loss due to a borrower's defaulting ...
Related Articles
  1. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  2. Investing

    Amazon Circles Toy Market After Toys R Us Demise

    The e-commerce giant is borrowing ideas used by traditional retailers in a bid to fill the vacuum left by defunct toy chain Toys "R" Us.
  3. Investing

    Billionaire Starts GoFundMe Page Save Toys R Us

    The CEO of toymaker MGA Entertainment hopes that a $200M initiative can keep the brand alive.
  4. Investing

    Balancing the Different Risks Investors Face

    One of the keys to investing successfully is to balance different types of risk.
  5. Investing

    Why Amazon Could Buy Some Toys R Us Stores

    The online retailer could open up Amazon-branded stores to showcase products such as Alexa.
  6. Investing

    Understanding Risk is Key to Your Investing Strategy

    Here's why considering all types of risk is crucial for a successful investment plan.
  7. Tech

    The Importance of Healthcare Risk Management

    Risk management is especially important in healthcare because human lives might be on the line. Here are some strategies to map out a plan.
  8. Financial Advisor

    Risk Tolerance Only Tells Half The Story

    Just because you're willing to accept a risk, doesn't mean you always should.
  9. Investing

    Low-Risk vs. High-Risk Investments for Beginners

    Understanding risk is key to better investing. Learn how to determine where risk lies and the difference between low risk and high risk are crucial.
  10. Investing

    Using Logic To Examine Risk

    Know your odds before you put your money on the table.
RELATED FAQS
  1. Financial Risk vs Business Risk

    Understand the key differences between a company's financial risk and its business risk – along with some of the factors ... Read Answer >>
  2. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
  3. How can companies reduce internal and external business risk?

    Understand the difference between two types of operational risk – internal risk and external risk – and how companies can ... Read Answer >>
  4. The risks businesses face in international finance

    When an organization engages in international financing activities, it takes on additional risk, including foreign exchange ... Read Answer >>
Trading Center