Financial Risk Is the Additional Risk To The Shareholders

The Financial risk is the additional risk to the common stockholders due to the use of debt financing. The use of debt increases the probability of bankruptcy of the firm.

The Stock price risk is the underlying operational risk of the business. Read more about it here. And the Financial risk increases the underlying operating risk.

How so?

Financial risk encompasses both the risk of possible insolvency and the added variability in Return on Equity that is induced by the use of debt.

Yes, Return on Equity will go up by the use of debt, but overuse of it will surely harm the cash flow from operation. Since interest payments will become a financial burden to the company.

If there is one thing which makes good companies fail, its because of their debt.

General Electric (Including GE Financ) had $110 billion short and long term debt. And its outstanding interest payments was $657 million at December 31, 2018.

Facebook Inc. has zero debt and paid zero interest payment in FY 2018.

Facebook and General Electric five-year stock performance.
(Source: Google Finance)

By no means, I am claiming that the stock is falling or rising just because of debt. However, debt substantly increases the underlying business risk.

It is desirable for wise investors to avoid companies, good or bad, with high debt.

Be advised that Apple used debt financing to increase the Return on Equity to its shareholders. Apple already has a huge cash balance and they issued bonds in Japan with the coupon payment of less than 2%.

Little is better whether it’s debt or blog post!

Do share your thoughts in the comment section below.

Disclaimer: Long position on Apple and Facebook.

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