Financial risk refers to a condition where a company with a certain amount of debt will fail to repay them in a given time period. In other words, financial risk means the risk of losing money by investing it in a lossmaking company.
Investors usually remain averse to risky companies and hence calculating the financial risk is of paramount importance to them. In general, the more debt a company has, the more will be its financial risk.
Financial risks can lead to loss of shareholders’ income, as the money is lost while carrying on with a loss-making company. However, it is not easy to identify the companies or industries that are prone to losses at once. It may need enough experience of financial markets, the macroeconomic conditions, and the overall market scenario to identify a potential financial risk of a company.
Depending on the nature, financial risks can be divided into the following categories −
Companies may be prone to default, or they may be unable to repay the debt due to their overall cost structure or the huge burden of debt they may have. These companies look for over-growth by taking increasing debt and have an eye on the overall profit that may have been made without considering the results of a fallout from the tracks. Therefore, investors must be aware of the threats and issues faced by such companies.
Individuals may face financial risks when they take too many loans or abuse the financial tools they are provided with. For example, too much use of credit cards may create a burden of huge debts on them which may cause serious impacts on their credit history. In such situations, the person may find it troublesome to get a new loan and may face financial hardship due to this.
Governmental financial risk means that the government fails in managing the monetary policy and in repaying the interests on bonds issues by it. Usually, such fallouts are hard to find because governments attach fewer burdens to bonds issued by it.
Financial markets are also prone to risks. These risks may be created by unfavorable market conditions, macroeconomic factors, change in government policies, and defaulting possibilities of large corporations. The bankruptcy of Lehmann Brothers and the subsequent recession is a good example of market risks associated with investments in the share markets.
It is notable that forecasting economic or financial risk is a tough task because it needs to predict the future. There is always some uncertainty attached to future forecasts, so companies and individuals should take enough precaution while measuring the future gains or losses with their investments.