A simple real estate analogy can help explain the difference between financial risk and business risk. The value of a home at any given time depends on the housing stock, current and expected population growth, current and projected employment levels, and various other demographic and economic factors. These factors are analogous to business risk in that they affect the value of your home.
Conversely, the way a particular homeowner finances their home will reflect financial risk, not business risk, as it does not affect the value of the home. In other words, the home is worth what the home is worth because anyone who buys the home is free to fund the acquisition at their own discretion. One person may want to take on more debt (and financial risk) than the next, but it doesn’t affect the value of the home.
In theory, the optimal amount of financial leverage and the resulting total cost of capital for a given investment depends on the investment, not the advisor. In general, companies with property, plant and equipment and stable cash flows can service more debt than companies with fewer property, plant and equipment and irregular cash flows. While estimating the optimal leverage for a given investment is a complex task, it is clear that excessive leverage increases the risk of bankruptcy.
In summary, financial leverage is similar to a double-edged sword in that it cuts both ways. Just as greater leverage increases stock returns when an investment is performing well, losses can also increase in cases where the targeted returns (cash flows) are not achieved. How much and under what conditions debt should be used to fund an investment varies from company to company. However, investors need to remember that the expected reward for taking greater financial risk should adequately compensate them for the additional risk. The proposed purchase price and capital structure in Cindy’s case may or may not be reasonable, but the distinction between business and financial risk helps Cindy evaluate her options and make an informed decision.
JT Dhoot is a Chartered Business Valuator and Accredited Appraiser with over 12 years of experience in valuation, real estate development and private equity across Canada.