What is the difference between business risk and financial risk?

Business risk and financial risk are two distinct concepts that are critical in the field of corporate finance. Business risk pertains to the potential for loss due to factors related to a company's core operations. This includes risks arising from competition, market demand, regulatory changes, and operating inefficiencies. Essentially, business risk is driven by the nature of the business itself and the environment in which it operates.

On the other hand, financial risk is associated with the structure of a company's capital, particularly the amount of debt it uses to finance its operations. Financial risk arises from the use of leverage; when a company takes on debt, it introduces the risk that it may not be able to meet its financial obligations during downturns or tough economic times. This means that while the business performance might be stable, factors such as high levels of debt can introduce additional risks to shareholders.

Therefore, the correct differentiation indicates that business risk is tied to operational activities, whereas financial risk correlates with how a firm finances these activities through its capital structure. This understanding is crucial for finance professionals when assessing overall company risk and making strategic decisions regarding debt financing versus equity financing.