Financial Risks
Financial Risks⇒ are the risks that are connected to the financial health of the company.
Borrowing money creates a form of financial risk for the following reasons:
- Lack of cash flow may cause the firm to be unable to pay its interest and other obligations when they become due. As the proportion of fixed cost (that is, debt) financing to total financing in a firm’s capital structure increases, fixed cash outflows for interest expense also increase. When cash outflows for interest expense increase, the possibility of insolvency also increases.
- The payment of interest creates increased variability in earnings per share because the fixed interest costs increase the volatility of a firm’s earnings before taxes (EBT)
Examples include:
- Volatility of foreign currencies (exchange rate risk)
- Volatility of interest rates (interest rate risk)
- Volatility of prices of commodities (inputs)
- Credit risk
- Liquidity risk
- Market risk (decline in FMV of financial instruments)