Financial Risk

Take a business and change nothing about what it sells, what it costs to run, or how many customers it has. Fund it with borrowing instead of equity. The risk to its owners has gone up, and nothing about the business changed.

That added risk is financial risk, and it comes from one feature of debt: interest is a fixed payment, made first. The lender is paid whether the year was good or bad. Whatever survives that payment belongs to the shareholders — and because a fixed amount has been taken off the top, what survives swings much harder than the operating profit it came from.

The workbook also calls this financial leverage, and the two names are used interchangeably.

Fixed financing costs magnify the movement in operating profit on its way down to the owners, in exactly the way fixed operating costs magnify the movement in sales on its way down to operating profit.

Take a company with EBIT of Rs 100 crore in a normal year, moving to Rs 130 crore in a good one and Rs 70 crore in a bad one. Compare two capital structures, ignoring tax:

Operating profit moved ±30% around the middle case. The unlevered owner's return moved ±30% too. The levered owner's return moved ±50%.

And the downside keeps going. At EBIT of Rs 40 crore the unlevered company still earns 8% on equity; the levered one has not covered its interest at all.

This is also the mechanism behind a leveraged buyout, and behind the leverage a Category III AIF may take: SEBI caps that at two times the fund's Net Asset Value, because the amplification works identically on a fund's balance sheet and on a company's.

A Category II AIF is offered Rs 50 crore of equity in a mid-market manufacturer at a Rs 250 crore pre-money valuation. The company already has Rs 300 crore of bank debt at 11% against equity of Rs 200 crore.

The business itself is steady — EBIT has run between Rs 55 crore and Rs 75 crore for four years. But the interest bill is fixed:

Interest = 300 × 11% = Rs 33 crore every year

Good year:  EBIT 75 − 33 = Rs 42 cr before tax
Bad year:   EBIT 55 − 33 = Rs 22 cr before tax

EBIT varies by ±15% around Rs 65 crore. Pre-tax profit varies by ±38% around Rs 32 crore — two and a half times as much. The business risk is modest; the financial risk is not.

Now suppose rates rise 200 basis points at refinancing. Interest becomes Rs 39 crore, and in a bad year pre-tax profit falls to Rs 16 crore — a 27% fall in owners' earnings from a change that has nothing to do with the company's customers.

That is what the fund is actually underwriting when it buys into a levered balance sheet, and it is why a due-diligence checklist looks at the debt schedule before it looks at the growth plan.

Chapter 1, section 1.4.3, defines financial risk as the risk arising from the means of financing assets — debt or equity — and notes that it is popularly known as financial leverage. It is set almost invariably as a paired question with business-risk: which risk comes from the nature of the business, and which from the way it is funded. Chapter 7 carries the same idea into risk factor 12, leverage risk at fund level for a Category III AIF.

• Financial risk is the risk from how the firm is funded, not from what it does. That second one is business-risk, and questions test the pair together.
• A debt-free company has no financial risk at all. That is not a trick; it is the definition.
• The workbook calls it financial leverage. If a question uses that phrase, it is asking about financial risk, not about operating leverage.
• Leverage amplifies gains too. The levered structure earned 90% on equity in the good year. The risk is the variability, not the direction.
• Debt is not the same as financial distress. Financial risk is present at any level of borrowing; distress is what happens when the fixed claim cannot be met.
• At fund level, SEBI caps a Category III AIF's leverage at two times NAV — a regulatory ceiling on financial risk, not a comment on whether taking it is wise.