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Funding risk is the possibility that a business might not have access to the financing it needs at an affordable rate. Typically, a business plans to use a combination of equity and credit financing to fund operations. The cost of financing is the interest that the company has to pay to secure the outside funds. A business can only anticipate the future interest rate on a source of funds. The risk that the credit market may change and funds become more expensive is the funding risk in a business' financing plan.
Businesses borrow money just like individuals. Borrowed funds, or credit, can pay for inventory, help a business make payroll or enable it to purchase equipment or facilities. Whenever a business borrows money, the lender sets an interest rate, which is an additional amount that must be paid on top of the return of the principal amount borrowed. The interest paid on borrowed money is the cost to the business of using that funding source.
There are a number of ways a business can finance operations with borrowed funds. It can take out a loan from the bank or open a line of credit. Some vendors extend businesses credit terms that allow 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 can be fixed at the time the loan is made or can vary periodically as market conditions and the economy changes. Some sources of funds tie their interest rates to some general standard, such as the rate of interest a government is charging on its treasury bonds. Loan interest that is set up in such a way might require three percentage points above the government interest rate, for example.
A business can never really know what the cost will be to borrow funds in the future. It can make a reasonable estimate, based on current conditions. Sudden economic changes can render those assumptions obsolete, however, and the needed financing may end up being much more expensive to acquire. The possibility that this may happen is the funding risk that is inherent in any business scenario that requires financing.
Typically, the cost of financing directly affects a business' cash flow. If a business needs a loan to finance a new project, for example, and the interest rates change between the time the loan was discussed and the time it actually closes, it may put the entire project in jeopardy. Businesses seek to minimize funding risk to the extent possible by having multiple sources of credit available. Operating a business with few sources of fixed-rate financing is considered a high funding risk.
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