Since a firm is owned by shareholders all firms will be mainly interested in its market risk rather than the total risk which is the risk faced by the firm. The firm’s market risk is also called non-diversifiable risk.
The firms are interested in diversifiable risk as they avoid this risk by diversification. Likewise, shareholders, on the other hand, are more interested in the business’s market risk than its stand-alone risk.
For time being, the total risk of a firm is considered. The firm’s total risk is represented by the volatility of the firm’s return on equity (ROE). The ROE of the firm is calculated by dividing Net income by Equity.
The main 2 constituents of a firm’s total risk are the financial risk (depending on the firm’s financing decision) and the business risk (which is risk depending).
As far as a firm’s business risk is concerned, it shows the uncertainty of a firm’s Return on Assets (ROA). As a definition of business risk, it can be defined as the basic risk of doing business. The business risk of a firm can be shown by the volatility of its ROA.
The ROA, in this case, is Returntoinvestors divided by the Total Assets of the company. Also, it can be Net Income divided by the total investments in which investment is a total of Debt and Equity.
When Debt is 0, ROA will be equal to a firm’s ROE. The volatility of a firm’s ROE is used to represent its business risk. To extract the influence of a firm’s financing decision and to focus mainly on the factors affecting a firm’s operation, the attention will be focused on an unlevelled firm.
Business risk are affected by factors like demand variability, sales price variability, input cost variability, the ability for a timely ,cost-effective manner of developing new products, ability to adjust output prices for changes in input price and also a firm’s ratio of fixed cost relative to its variable cost which is called a firm’s operating leverage.
So, any one of the above-mentioned factors affects the business risk and net income. The impact is directly proportional to business risk.
In the case of most of the firms the financing is not done fully with equity unlike in the case of unlevelled firms were the business risk of the firm is represented by the volatility of its ROE. In most cases, the financing of the firms is with a combination of debt and equity.
The point of consideration is how the ROE of a firm is affected by its financial leverage. The ROE becomes more volatile when a firm changes from mainly equity financing to that of a mixture of debt and equity financing.
The main thing, which a firm’s financial risk represents, is the impact of a firm’s financing decision on its ROE. The firms take on the additional responsibility of financing the debt when it uses the debt. Bankruptcy can be caused at the end when the firms are unable to pay the interest.
The chances for this bankruptcy increases as the amount of debt that the firm uses increases. The main thing that should be kept in mind is that a common stakeholder is the one who has the last claim on a firm’s assets.
As the firm’s debt increases its financial stress also increases which is the main theory behind the financial risk.