When you invest in stocks, typically, the greater the risk, the greater the reward. Risk is both a subjective term and one that you can analyze using several financial measures. Knowing how to find specific risk factors in a business will help you calculate financial risk ratios and choose whether or not a particular stock is right for your portfolio.
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What Is Financial Risk?
Financial risk is broadly defined as the possibility that a company might go bankrupt, either dissolving or seeking protection under Chapter 7 of the U.S. bankruptcy codes. Categories of risk include market risk, credit risk, liquidity risk and operational risk
You can't accurately predict subjective factors, such as an economy crashing, a technology disruption that makes a product obsolete or a supply chain failure in an industry. However, in investing, risk is often measured by the amount of debt a company has in relation to several other measurable financial factors.
Different experts use different risk factors to determine overall risk, but several factors are common measurements used by most professional investors. These include debt capacity ratio, EBIT and EBITDA, debt-to-equity ratio and interest coverage ratio.
Examining these key financial indicators of a company's financial performance, which you can do using an annual or quarterly report, will help you better examine each financial risk ratio.
Look at Debt Capacity
Companies often need to borrow money to continue operations. For example, a business gets an order for $10 million worth of widgets. It costs the company $6 million to make the widgets, providing a nice profit. However, if the company doesn't have enough cash to purchase materials and hire labor, it can't fill the order. It will need to borrow money to make the widgets and make a profit.
Debt capacity is the ability of a company to take on debt and repay it on time, according to the Corporate Finance Institute. Think about your personal finances. If you have credit cards that offer you $15,000 worth of credit, but you've already made $14,000 worth of charges, you are highly leveraged and the risk that you are going to default on your repayments is much greater than if you only have $3,000 worth of charges on your cards.
Read More: How to Calculate EBIT
Look at EBIT and EBITDA
Businesses provide information about earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA). While both provide accurate information about a company's profitability, EBIDTA gives investors a better picture of how debt affects a company's performance, explains Oracle NetSuite.
Look at Debt-to-Equity Ratio
The debt-to-equity ratio refers to the amount of debt a business owes, along with other financial liabilities, compared to the amount of current shareholder equity. The debt-to-equity ratio is also known as the risk ratio, or gearing. The same healthy risk ratio for one company might be a problem for another, depending on the industry the two companies are in or their cash flow.
Look at Interest Coverage Ratio
Not only does debt factor into a risk assessment, but so does the amount of interest the debt is generating and a company's ability to pay it back. You can calculate the interest coverage ratio by dividing the interest expense by EBIT or EBITDA. The lower the interest coverage ratio, the more the company is leveraged and the higher the risk.