What risk is involved in financing a business?
Businesses and business risk are two phenomenons that are intrinsically related. This is a statement that holds true for both business startups, business gurus and the even these who only hold business ideas. British super business man Sir Richard Branson, he of the Virgin Group, attempted to cross the Atlantic by boat in 1985. The result was a shipwreck that resulted in near disaster.
However, on the business front Richard has excelled. Kenneth Lay and Jeffrey Skilling also took business risks. Their result was rather devastating. They are responsible for, as was reported in the Business week, “transforming Americas number seven company and the icon of the New Age corporate cool to a synonym for Bubble Era greed and deceit”.
There are many risks involved in businesses and especially business financing. They include credit risk, legal risk, liquidity risk, market risk, volatility risk and operational risk.
These may apply to both the lender and the borrower or only affect one of the parties. Let us define and relate them to business financing.
Business finance risks
Credit risk is that risk of loss as a result of the borrowers non-payment of a loan be it the principal or the interest. For these, lenders will usually rank them as appropriate and charge a high or low price. For example, unsecured personal loans or mortgages always attract higher interests due to the high risk. Overdrafts and credit cards are controlled through the setting of credit limits while some loans will require only property as security. Protective covenants are also inserted in business financing agreements to protect lenders.
Legal and regulatory risk occurs when provisions of a particular legislation have not been adhered to or when the legislature repeals or amends the law in a way that adversely affects the relationship between parties. The legality of a business financing transaction may be affected by these changes especially if the new law or the amendment applies retrospectively.
Liquidity risk in business financing presents itself when a given security or asset cannot be traded quickly enough in the market in order to prevent loss or make the required profit. Lenders will usually want to know if the collateral given will face asset liquidity or funding liquidity risk. The higher the possibility of failing to get buyers will mean that the risk is higher and thus no lending or high interest rates.
Market risk will occur in business financing when the value of an investment decreases due to market forces. Business financiers will always want to have, as collateral, assets that have a strong presence in the market. For example, land is considered to be safer than equity due to its tendency to always appreciate in value.
Operational risk in business financing will arise when executing the normal day to day activities of the company. Although this category will encompass some of the other risks, it specifically deals with the loss from inadequate or failed internal processes, human and systems. It may also be from external events (The Basel Committee). For business people, financing a business whose internal structures have neared collapse may not make sense.
Volatility risk refers to the deviation from the normal performance of a financial instrument over a specific time limitation. The current situation in the world markets typifies this. When financing a business, potential investors will want to know if the venture will go the Fannie and Freddie way.
Business financing and the risks involved
Prudence will only lead to one conclusion. All business financing is risky.