Risk and Return

What is 'Financial Risk'

Financial risk is the possibility that shareholders 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 its 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.
Financial risk is the general term for many different types of risks related to the
finance industry. These include risks involving financial transactions such as company
loans, and its exposure to loan default. The term is typically used to reflect an
investor's uncertainty of collecting returns and the potential for monetary loss.
Financial risk refers to a company's ability to manage its debt and financial leverage, while
business risk refers to the company's ability to generate sufficient revenue to cover its
operational expenses. An alternate way of viewing the difference is to see financial risk as the
risk that a company may default on its debt payments, and business risk as the risk that the
company will be unable to function as a profitable enterprise.
What is 'Unsystematic Risk'
Unsystematic risk is unique to a specific company or industry. Also known as “non-
systematic risk,” "specific risk," "diversifiable risk"

Unsystematic risk can be described as the uncertainty inherent in a company or

industry investment. Types of unsystematic risk include a new competitor in the
marketplace with the potential to take significant market share from the company
invested in; a regulatory change, which could drive down company sales; a shift in
management; and/or a product recall

What is 'Systematic Risk'

Systematic risk is the risk inherent to the entire market or market segment. Systematic
risk, also known as “undiversifiable risk,” “volatility,” or “market risk,” affects the overall
market, not just a particular stock or industry. This type of risk is both unpredictable and
impossible to completely avoid. It cannot be mitigated through diversification, only
through hedging or by using the correct asset allocation strategy.
Business Risk

Business risk refers to the basic viability of a business, the question of whether a company will be able to make
sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial
risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business
must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent,
and office and administrative expenses.

The level of a company's business risk is influenced by factors such as its cost of goods, profit margins,
competition, and the overall level of demand for the products or services that it sells.

Business risk is often categorized into systematic risk and unsystematic risk. Systematic risk refers to the general
level of risk associated with any business enterprise, the basic risk resulting from fluctuating economic, political
and market conditions. Systematic risk is an inherent business risk that companies usually have little control over,
other than their ability to anticipate and react to changing conditions.

Unsystematic risk, however, refers to the risks related to the specific business in which a company is engaged. A
company can reduce its level of unsystematic risk through good management decisions regarding costs, expenses,
investments and marketing. Operating leverage and free cash flow are metrics that investors use to assess a
company's operational efficiency and management of financial resources.
A company's financial risk is related to the company's use of financial leverage and debt
financing, rather than the operational risk of making the company a profitable enterprise.
Financial risk is concerned with a company's ability to generate sufficient cash flow to be able
to make interest payments on financing or meet other debt-related obligations. Obviously, a
company with a relatively higher level of debt financing carries a higher level of financial risk,
since there is a greater possibility of the company not being able to meet its financial
obligations and becoming insolvent.

Some of the factors that may affect a company's financial risk are interest rate changes and the
overall percentage of its debt financing. Companies with greater amounts of equity financing
are in a better position to handle their debt burden. One of the primary financial risk ratios
that analysts and investors consider to determine a company's financial soundness is the
debt/equity ratio, which measures the relative percentage of debt and equity financing.

Debt/Equity Ratio = Total Liabilities / Shareholders' Equity

Foreign currency exchange rate risk is a part of the overall financial risk for companies that do
a substantial amount of business in foreign countries.
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.
Risk is inherent in any business enterprise, and good risk management is an essential
aspect of running a successful business. A company's management has varying levels
of control in regard to risk. Some risks can be directly managed; other risks are largely
beyond the control of company management. Sometimes, the best a company can do
is try to anticipate possible risks, assess the potential impact on the company's
business and be prepared with a plan to react to adverse events.
1. Market Risk
Market risk involves the risk of changing conditions in the specific marketplace in
which a company competes for business. One example of market risk is the
increasing tendency of consumers to shop online. This aspect of market risk has
presented significant challenges to traditional retail businesses. Companies that
have been able to make the necessary adaptations to serve an online shopping
public have thrived and seen substantial revenue growth, while companies that have
been slow to adapt or made bad choices in their reaction to the changing
marketplace have fallen by the wayside.
This example also relates to another element of market risk – the risk of being out
maneuverer by competitors. In an increasingly competitive global marketplace, often
with narrowing profit margins, the most financially successful companies are most
successful in offering a unique value proposition that makes them stand out from the
crowd and gives them a solid marketplace identity.
2. Credit Risk
Credit risk is the risk businesses incur by extending credit to customers. It can also
refer to the company's own credit risk with suppliers. A business takes a financial risk
when it provides financing of purchases to its customers, due to the possibility that a
customer may default on payment.
A company must handle its own credit obligations by ensuring that it always has
sufficient cash flow to pay its accounts payable bills in a timely fashion. Otherwise,
suppliers may either stop extending credit to the company, or even stop doing
business with the company altogether.

3. Operational Risk
Operational risks refer to the various risks that can arise from a company's ordinary
business activities. The operational risk category includes lawsuits, fraud risk,
personnel problems and business model risk, which is the risk that a company's
models of marketing and growth plans may prove to be inaccurate or inadequate.
4. Liquidity Risk
Liquidity risk includes asset liquidity and operational funding liquidity risk. Asset
liquidity refers to the relative ease with which a company can convert its assets into
cash should there be a sudden, substantial need for additional cash flow. Operational
funding liquidity is a reference to daily cash flow.
General or seasonal downturns in revenue can present a substantial risk if the
company suddenly finds itself without enough cash on hand to pay the basic
expenses necessary to continue functioning as a business. This is why cash flow
management is critical to business success – and why analysts and investors look at
metrics such as free cash flow when evaluating companies as an equity investment.
Return is a profit on an investment. It comprises any
change in value and interest or dividends or other such
cash flows which the investor receives from the
investment. It may be measured either in
absolute terms (e.g., dollars) or as a percentage of the
amount invested.
A return, also known as a financial return, in its simplest
terms, is the money made or lost on an investment. A
return can be expressed nominally as the change in
dollar value of an investment over time. A return can be
expressed as a percentage derived from the ratio of
profit to investment.
Positive Return
A positive return is the profit, or money made, on an
investment or venture.
Negative Return
A negative return is the loss, or money lost, on an
investment or venture.
Nominal Return
A nominal return is the net profit or loss of an
investment expressed in nominal terms. It can be
calculated by figuring the change in value of the
investment over a stated time period plus any
distributions minus any outlays. Distributions received by
an investor depend on the type of investment or venture
but may include dividends, interest, rents, rights,
benefits or other cash-flows received by an investor.
Outlays paid by an investor depend on the type of
investment or venture but may include taxes, costs, fees,
or expenditures paid by an investor to acquire, maintain
and sell an investment. For example, assume an investor
buys $1,000 worth of publicly traded stock, receives no
distributions, pays no outlays, and sells the stock two
years later for $1,200. The nominal return in dollars is
$1,200 - $1,000 = $200.
Percentage Return or Return on Investment (ROI)
A percentage return is a return expressed as a percentage. It is known as the Return
on Investment (ROI). ROI is the return per dollar invested. ROI is calculated by
dividing the dollar return by the dollar initial investment. This ratio is multiplied by 100
to get a percentage. Assuming a $200 return on a $1,000 investment, the percentage
return or ROI = ($200 / $1,000) x 100 = 20%.

Holding Period Return

A holding period return is an investment's return over the time it is owned by a
particular investor. Holding period return may be expressed nominally or as a
percentage.
Return Annualization
Returns over periodic internals of different lengths can only be compared when they
have been converted to same length intervals. It is customary to compare returns
earned during year long intervals. The process of converting shorter or longer return
intervals to annual returns is called annualization.
To annualize is to convert a
rate of any length into a rate
Return Of Capital that reflects the rate on an
annual, or yearly, basis. This
Return of capital is a payment received is most often done on rates
from an investment that is not considered of less than one year, and it
a taxable event and is not taxed as income. usually does not take into
account the effects of
Instead, return of capital occurs when an compounding.
investor receives a portion of his original
investment, and these payments are not
considered income or capital gains from the
investment.
Returns Ratios
Returns ratios are a subset of financial ratios that measure how effectively an investment is being managed.
They help to evaluate if the highest possible return is being generated on an investment. In general, returns
ratios compare the tools available to generate profit, such as the investment in assets or equity, to net income,
the actual profit generated. Returns ratios make this comparison by dividing selected or total assets or equity
into net income. The result is a percentage of return per dollar invested that can be used to evaluate the
strength of the investment by comparing it to benchmarks like the returns ratios of similar investments,
companies, industries, or markets. Two commonly used returns ratios are:

Return on Equity
Return on Equity (ROE) is a profitability ratio figured as net income divided by average shareholder's equity that
measures how much net income is generated per dollar of stock investment. If a company makes $10,000 in net
income for the year and the average equity capital of the company over the same time period is $100,000, the
ROE is 10%.

Return on Assets
Return on Assets (ROA) is a profitability ratio figured as net income divided by average total assets that
measures how much net profit is generated for each dollar invested in assets. It determines financial leverage
and whether enough is earned from asset use to cover the cost of capital. Net income divided by average total
assets equals ROA. For example, if net income for the year is $10,000, and total average assets for the company
over the same time period is equal to $100,000, the ROA is $10,000 divided by $100,000, or 10%
Currency of measurement