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Financing risk is the possibility that a business may not have access to affordable financing. Borrowed funds come with interest rates that can change, affecting a company’s cash flow. To minimize financing risk, businesses should have multiple sources of credit available.
Financing risk is the chance that a business will not have access to the financing it needs at an affordable rate. Typically, a company plans to use a combination of equity and credit financing to finance operations. The financing cost is the interest that the company has to pay to secure the external funds. A company can only anticipate the future interest rate on a source of funds. The risk that the credit market changes and funds become more expensive is financing risk in a company’s financing plan.
Businesses borrow money just like people. Borrowed funds, or credit, can pay for inventory, help a business run payroll, or allow it to purchase equipment or facilities. Every time a business borrows money, the lender sets an interest rate, which is an additional amount that must be paid on top of the repayment of the borrowed loan amount. The interest paid on the money borrowed is the cost to the business of using that source of financing.
There are several ways a business can finance operations with borrowed funds. You can take out a loan from the bank or open a line of credit. Some vendors extend companies’ credit terms allowing them to make purchases but pay at a later time. Public corporations can also borrow money from the public by issuing bonds.
All of these sources of borrowed funds charge a business a different interest rate for the extension of credit. Interest rates may be fixed at the time the loan is made or may vary periodically as market and economic conditions change. Some sources of funds tie their interest rates to some general standard, such as the interest rate a government charges on its treasury bonds. Loan interest set in such a way may require three percentage points above the government interest rate, for example.
A business can never really know what the cost of borrowing funds will be in the future. You can make a reasonable estimate, based on current conditions. However, sudden economic changes can make those assumptions obsolete, and the necessary financing can end up being much more expensive to acquire. The possibility of this happening is the financing risk inherent in any business scenario that requires financing.
Typically, the cost of financing directly affects a company’s cash flow. If a business needs a loan to finance a new project, for example, and interest rates change between the time the loan was discussed and the time it actually closes, it can jeopardize the entire project. Businesses seek to minimize financing risk as much as possible by having multiple sources of credit available. Operating a business with few sources of fixed-rate financing is considered high financing risk.
Smart Asset.
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