(Moles and Terry, 1997). A firm faces finances risk if there is a high probability that it might be unable to meet its fixed financial obligations or prior chares such as interest, principal repayments, lease payments, or preferred stock dividends. Financial risk is therefore risk arising from the use of debt finance, which requires periodic payments of interest and principal and may not be covered by the firm's operating cash flows. (Moles and Terry, 1997).
The capital structure of a firm is made up of both debt and equity components. Although the use of debt in financing part of the firm's operations is advantageous to the firm, these advantages tend to disappear when too much debt is used. In effect when debt is used above the optimum level, the result is financial distress. (Ross et al, 1999). Ross et al (1999) asserts that debt puts pressure on the firm, since interest and principal repayments as well as short-term payables are financial obligations. In the event where these obligations are not met, the firm may risk some sort of financial distress. (Ross et al, 1999). Debt obligations are fundamentally different from stock obligations in that bondholders are legally entitled to interest and principal repayments more than stockholders are legally entitled to dividends. (Ross et al, 1999). ...Show more