Financial risk
• This refers to the variability in earnings available to ordinary shareholders as a result of using debt finance which has a fixed interest charge.
• In times of excessive profits, the earnings are enhanced due to lower charges for interest. However during period of low profits, the shareholders risk not getting any return since interest on debt is to be paid irrespective of profits earned.
Operating risk
• Operating risk on the other hand is caused by incurrence of fixed costs in production process. It is the variability in operating income as a result of incurring fixed operating costs.
• When fixed costs are high, this variability will be higher for any change or movement in sales and hence operating risk is higher.