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. Operational Risk

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

    Specific risk is a risk that affects a minimal number of assets, ...
  3. Delivery Risk

    Delivery risk refers to the chance that one side may not fulfill ...
  4. Liquidity Risk

    Liquidity risk refers to the marketability of an investment and ...
  5. Risk Shifting

    Risk shifting is the transfer of risk to another party.
  6. Risk

    Risk takes on many forms but is broadly categorized as the chance ...
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

    How Amazon Is Destroying Toys R Us

    As cash-heavy rivals step up their digital game, Toys R Us is forced to focus on its debt pile.
  3. Investing

    The Risks Associated with Common Investments

    Investing inherently involves some risk. Here are some of the different types of investment risks.
  4. Insights

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  5. Managing Wealth

    Why Companies Need Risk Management

    Implementing risk management strategies can save an entire organization from failure. Is yours up to snuff?
  6. 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.
  7. Insights

    Wal-Mart, Toys R Us Can't Keep Up With the Demand for Fidget Spinners

    Fidget spinners are all the rage with young children, forcing Walmart and Toys R Us to scramble to capitalize on the trend.
  8. Financial Advisor

    The Importance of a Client's Risk Assessment

    Financial advisors and money managers must do a detailed risk assessment regarding each client before they can recommend a course of action.
  9. Investing

    Understanding Risk is Key to Your Investing Strategy

    Here's why considering all types of risk is crucial for a successful investment plan.
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. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
  3. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ... Read Answer >>
  4. In what types of financial situations would credit spread risk be applied instead ...

    Find out when credit risk is realized as spread risk and when it is realized as default risk, and learn why market participants ... Read Answer >>
  5. What are some examples of risk management techniques?

    Understand what risk management is in business and why it is a necessary component of ongoing business planning, and review ... Read Answer >>
  6. What are some common measures of risk used in risk management?

    Learn about common risk measures used in risk management and how to use common risk management techniques to assess the risk ... Read Answer >>
Trading Center