Financial Risk

What is 'Financial Risk'

Financial risk is the possibility that shareholders 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 its 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 general term for many different types of risks related to the finance industry. These include risks involving financial transactions such us company loans, and its exposure to loan default. The term is typically used to reflect an investor's uncertainty of collecting returns and the 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 is also referred to as default risk. This type of risk is associated with people who borrowed money and who are unable to pay for the money they borrowed. As such, these people go into default. Investors affected by credit risk suffer from decreased income and lost principal and interest, or they deal with a rise in costs for collection.

Liquidity risk involves securities and assets that cannot be purchased or sold fast enough to cut losses in a volatile market. 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.

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. Equity risk covers the risk involved in the volatile price changes of shares of stock.

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.