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.