# How to Identify and Control Financial Risk

![Financial Risk](https://www.investopedia.com/thmb/eK4Rtkueww4NsbhnhE9UvOIRCSM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/TermDefinitions_FinancialRisk_4-3-edit-77707a14d4c44c75b3e32d9c1b9e45b1.jpg)

*Diversification, maintaining emergency funds, and managing debt effectively can help individuals, investors, and businesses mitigate financial risk. — Crea Taylor / Investopedia*

> **Definition**
>
> Financial risk is the possibility of a financial loss. It includes currency risk, credit risk, liquidity risk, and operational risk.

## What Is Financial Risk?

Financial risk is measured by the loss of [capital](https://www.investopedia.com/terms/c/capital.asp) to interested parties. Financial markets face risk due to macroeconomic forces, changes to the market interest rate, and the possibility of default by sectors or large corporations.

Individuals face financial risk when they make decisions that jeopardize their incomes or ability to pay their debt. Corporations may face the possibility of default on debt they undertake or experience failure in an undertaking that causes a financial burden on the business.

### Key Takeaways

*   Financial risk is evident when a company’s cash flow is inadequate to meet its obligations.
*   Credit risk is also known as default risk.
*   Investors can use several financial risk ratios to assess a company’s future growth.

## Types of Risk

*   **Credit Risk**: The danger of [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp) is associated with borrowing money, and the risk of default occurs if a borrower is unable to repay a loan.
*   **Liquidity Risk**: May involve securities and assets that can’t be purchased or sold quickly enough to cut losses in a volatile market. This is known as [market liquidity risk](https://www.investopedia.com/articles/trading/11/understanding-liquidity-risk.asp), where there are few buyers but many sellers. Another risk is funding or cash flow liquidity risk. [Funding liquidity risk](https://www.investopedia.com/terms/l/liquidity-crisis.asp) is the possibility that a corporation won’t have capital to pay debt, forcing it to default and harming stakeholders.
*   **Speculative Risk**: Where a profit or gain has an uncertain chance of success. Perhaps the investor didn’t conduct proper research before investing, reached too far for gains, or invested too large a portion of their net worth into a single investment due to poor [speculation](https://www.investopedia.com/terms/s/speculation.asp).
*   **Currency Risk**: Investors holding foreign currencies are exposed to [currency risk](https://www.investopedia.com/terms/c/currencyrisk.asp) because factors such as interest rate changes and monetary policies can alter the value of their money. Changes in prices may occur due to market differences, political changes, natural calamities, or economic conflicts.
*   **Operational Risk**: Businesses can experience [operational risk](https://www.investopedia.com/terms/o/operational_risk.asp) when they have poor management or flawed financial reasoning. This is the risk of failing to succeed in its undertakings, and it’s based on internal factors.
*   **Specific Risk**: It’s referred to as a [specific risk](https://www.investopedia.com/terms/s/specificrisk.asp) when only one company or a handful of companies are struggling. This danger related to a company or a small group of companies includes issues related to capital structure, financial transactions, and exposure to default. The term is typically used to reflect an investor’s uncertainty about collecting returns and the accompanying potential for monetary loss.
*   **Asset-backed Risk**: Asset-backed securities are pools of various types of loans. Asset-backed risk is the chance that these securities may become volatile if the underlying securities also change in value. Subcategories of [asset-backed](https://www.investopedia.com/terms/a/asset-backedsecurity.asp) risk involve the borrower paying off a debt early and ending the income stream from repayments, and significant changes in interest rates.

## Market Impact

Many circumstances can impact the financial market and impact the monetary well-being of the entire marketplace when a critical sector of the market struggles, as was demonstrated during the [2007–2008 global financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp). Volatility brings uncertainty about the fair value of market assets. It reflects the confidence of the stakeholders that market returns match the actual valuation of individual assets and the marketplace as a whole.

Measured as [implied volatility (IV)](https://www.investopedia.com/ask/answers/032515/what-options-implied-volatility-and-how-it-calculated.asp) and represented by a percentage, this statistical value indicates the bullish or bearish view of investments: the market on the rise vs. the market in decline. Volatility or equity risk can cause abrupt price swings in shares of stock.

Defaults occur in the debt or bond market as companies or other issuers fail to pay their debt obligations, harming investors. Changes in the market [interest rate](https://www.investopedia.com/terms/i/interestrate.asp) can push individual securities into being unprofitable for investors, forcing them into lower-paying debt securities or facing negative returns.

> **Fast Fact**
>
> Fitch Ratings reported in January 2025 that the U.S. high-yield default rate was 2.58% for 2024. Fitch expects the rate to be 2.5% to 3.0% in 2025.

## Governments and Risk

Financial risk also refers to the possibility of a government losing control of its monetary policy and being unable or unwilling to control inflation and ultimately defaulting on its bonds or other debt issues.

Governments issue debt in the form of bonds and notes to fund wars, build bridges and other infrastructure, and pay for their general day-to-day operations. The U.S. government’s debt is [Treasury bonds](https://www.investopedia.com/terms/t/treasurybond.asp). They’re considered one of the safest investments in the world.

The list of governments that have defaulted on [debt](https://www.investopedia.com/terms/d/debt.asp) includes Belarus, Lebanon, Ghana, Sri Lanka, and Zambia.  Sometimes these entities only delay debt payments, or they pay less than the agreed-upon amount. Either way, it causes financial risk to investors and other stakeholders.  

## Tools to Control Financial Risk

Many tools are available to individuals, businesses, and governments that allow them to calculate the amount of financial risk they’re taking on. The most common methods that investment professionals use to analyze risks associated with long-term investments or the stock market include:

*   **Fundamental Analysis**: Evaluates a security’s intrinsic value by reviewing all aspects of the underlying business. [Fundamental analysis](https://www.investopedia.com/terms/f/fundamentalanalysis.asp) reviews a firm’s assets and its earnings.
*   **Technical Analysis**: Evaluates securities using statistics. [Technical analysis](https://www.investopedia.com/terms/t/technicalanalysis.asp) looks at historical returns, trade volume, share prices, and other performance data.
*   **Quantitative Analysis**: Uses financial ratio calculations to complete a [quantitative analysis](https://www.investopedia.com/terms/q/quantitativeanalysis.asp) of a company's historical performance.
*   **Debt-to-Capital Ratio**: measures the proportion of debt used given the total capital structure of the company when evaluating a business. The [debt-to-capital ratio](https://www.investopedia.com/terms/d/debt-to-capitalratio.asp) reveals if a high proportion of debt indicates a risky investment.
*   **Capital Expenditure (CapEx) Ratio**: [CapEx](https://www.investopedia.com/terms/c/capitalexpenditure.asp) divides cash flow from operations by capital expenditures to see how much money a company will have left to keep the business running after it services its debt.

> **Tip**
>
> Statistical and numerical analysis help identify risk, but investors should analyze trends over a long period for accurate readings.

## Example

Retailer Toys R Us was proof of the immense financial risk associated with debt-heavy [buyouts](https://www.investopedia.com/terms/b/buyout.asp) and capital structures that inherently heighten the risk for creditors and investors. Toys R Us voluntarily filed for Chapter 11 bankruptcy in September 2017. The company’s chair and CEO said in a statement released with the announcement that the company was working with debtholders and other creditors to restructure the $5 billion of long-term debt on its balance sheet.

Much of this financial risk stemmed from a $6.6 billion [leveraged buyout (LBO)](https://www.investopedia.com/terms/l/leveragedbuyout.asp) of Toys R Us in 2005 by investment firms Bain Capital, KKR & Co., and Vornado Realty Trust. The purchase took the company private and left it with $5.3 billion in debt secured by its assets. It never recovered, saddled by $400 million worth of interest payments annually.

Toys R Us announced in March 2018 that it would be liquidating all of its 735 U.S. locations to offset the strain of dwindling revenue and cash amid looming financial obligations. Toys R Us had difficulty selling many of its properties, an example of liquidity risk associated with real estate.

Debt holders Solus Alternative Asset Management and Angelo Gordon took control of the bankrupt company in November 2018 and discussed reviving the chain. The Associated Press reported in February 2019 that Tru Kids Brands, a new company staffed with ex-Toys R Us execs, would relaunch the brand with new stores later that year.

In late 2019, Tru Kids Brands opened two new stores, one in Paramus, New Jersey, and the other in Houston, Texas. Both locations closed in 2021 during the COVID-19 pandemic. Macy’s partnered with WHP Global to bring back the Toys R Us brand and announced in 2022 that it planned to bring Toys R Us to all its stores. WHP Global also opened two Toys R Us flagship stores: one in East Rutherford, New Jersey, in 2021, and the other in Bloomington, Minnesota, in 2023.

## How Do Investors Identify Financial Risks?

Identifying financial risks involves considering the risk factors that a company faces. This entails reviewing corporate balance sheets and statements of financial positions, understanding weaknesses within the company’s operating plan, and comparing metrics to other companies within the same industry. Several statistical analysis techniques are used to identify the risk areas of a company.

## How Does Hedging Reduce Risk?

Professional money managers, traders, individual investors, and corporate investment officers use [hedging techniques](https://www.investopedia.com/trading/hedging-beginners-guide/) to reduce their exposure to various risks. Hedging against investment risk means strategically using instruments such as options contracts to offset the chance of any adverse price movements in other assets.

## Is Financial Risk Systematic or Unsystematic?

Financial risk impacts every company, but it depends heavily on the operations and capital structure of an organization. Financial risk is, therefore, an example of [unsystematic risk](https://www.investopedia.com/terms/u/unsystematicrisk.asp) because it’s specific to each company.

## The Bottom Line

Financial risk occurs across businesses, markets, governments, and individual finances. These entities trade the opportunity to make profits and yield gains for the chance that they may lose money or face detrimental circumstances. Fundamental, technical, and quantitative analysis can help forecast risk.

> **Article Sources**
>
> 1.  Charles Schwab. “[Aligning Your Options With Implied Volatility](https://www.schwab.com/learn/story/aligning-your-options-with-implied-volatility).”
>     
> 2.  Fitch Ratings. “[2024 U.S. Issuer Default Rate Surpasses Pandemic Levels, Highlighting Ongoing Risk](https://www.fitchratings.com/research/corporate-finance/2024-us-issuer-default-rate-surpasses-pandemic-levels-highlighting-ongoing-risk-31-01-2025).”
>     
> 3.  Fitch Ratings. "[Sovereign Defaults at Record High](https://www.fitchratings.com/research/sovereigns/sovereign-defaults-at-record-high-29-03-2023)."
>     
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>     
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>     
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>     
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>     
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>     
> 9.  The Associated Press. “[Toys R Us Plans Second Act By Holiday Season](https://apnews.com/article/us-news-business-nj-state-wire-toys-ap-top-news-c54f0a6cc6334af18332158dc354f112).”
>     
> 10.  CBS News. “[Toys R Us Comeback Begins With Baby Steps: 2 New Stores to Open](https://www.cbsnews.com/news/toys-r-us-comeback-in-u-s-opening-new-stores-in-new-jersey-and-texas).”
>      
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>      
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