Business Risk

Anything that threatens a company's ability to achieve its financial goals is considered a business risk. It is influenced by a number of different factors.

Macro risks are not under the control of firms. Risks that arise out of political and economic imbalances can impact all businesses in an economy, a country or a region.

Industry risks apply to all firms in the same industry. They include cyclicality, industry structure, competitive intensity, competitive dynamics in the value chain, long-term growth and demand outlook, and other industry risks.

Company-specific risks include competitive position, product market risk, execution risk, capital investment risk, ESG risk and operating leverage.

Financial Risk

Financial risk comes with the use of leverage. It occurs when a company has a heavy reliance on debt as a funding source.

Liquidity becomes a much bigger concern for a management team that borrows, as principal and interest payments must be made to service its debt obligations. A company that uses debt in its capital structure becomes susceptible to rising interest rates and is required to adhere to the terms of its various credit agreements.

Measuring Operating and Financial Leverage

Total Leverage = Operating Leverage x Financial Leverage

Operating Leverage = Contribution / EBIT

Essentially, operating leverage boils down to an analysis of fixed costs and variable costs. Operating leverage is highest in companies that have a high proportion of fixed operating costs in relation to variable operating costs. Companies with high operating leverage can make more money from each additional sale if they don't have to increase costs to produce more sales.

Financial Leverage = EBIT/EBT

Although financial leverage may result in enhanced earnings for a company, it may also result in disproportionate losses. Losses may occur when the interest expense payments for the asset overwhelm the borrower because the returns from the asset are not sufficient.