How many of the following statements about business risk and financial risk are correct?
(A) Business risk depends upon the fixed operating costs of a firm.
(B) Higher fixed operating costs result in lower business risk for a firm.
(C) The total risk of a firm depends upon both its business risk and its financial risk.
(D) If the business risk of a firm is lower, its capacity to use debt is lower.
(E) Financial risk is the chance that a firm would fail to meet its payment obligations.
Choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Only three
(A) Business risk depends upon the fixed operating costs of a firm. — Correct. Business risk, also called operating risk, comes from fixed operating costs such as rent and salaries.
(B) Higher fixed operating costs result in lower business risk for a firm. — Incorrect. These costs must be paid whatever the sales. So higher fixed operating costs mean higher business risk.
(C) The total risk of a firm depends upon both its business risk and its financial risk. — Correct. A firm carries its operating risk and the risk from debt together. So the total risk depends on both.
(D) If the business risk of a firm is lower, its capacity to use debt is lower. — Incorrect. A firm with low business risk can bear more fixed financial charges. So its capacity to use debt is higher.
(E) Financial risk is the chance that a firm would fail to meet its payment obligations. — Correct. Financial risk comes from debt. It is the chance that the firm will fail to pay interest and repayments when due.
Business risk comes from fixed operating costs. Financial risk comes from the fixed charges on debt.
NCERT (2026-27 Edition): “Capital Structure … Debt is cheaper but is more risky for a business because the payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result, increased use of debt increases the financial risk of a company. Financial risk is the chance that a firm would fail to meet its payment obligations. …” “9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Apart from the financial risk, every business has some operating risk (also called business risk). Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.” |