Definition: Risk is a term in accounting and finance used to describe the uncertainty that a future event with a favorable outcome will occur. In other words, risk is the probability that an investment will not perform as expected and the investor will lose the money invested in the project. All business decisions and opportunities are based on this concept that future performance and returns are uncertain and rely on many uncontrollable variables.
What Does Risk Mean?
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This is the reason why the concept of risk is tied so closely with the concept return. As risk increases, the required level of return also must increase in order to sway the decision maker’s judgment. For example, a business owner wouldn’t make an invest that has a high probability of losing all of his or her money without the chance of making a healthy return. The reward is what entices people to make risky decisions, thus, the old saying—no risk, no reward.
Example
This is particularly true when making investment decisions. We often think of investments as stocks and bonds, but there are more types of investments than securities. For example, a production manager has to decide whether it will be worth investing company funds into a new machine that will increase production and require less direct labor. There is a certain amount of risk with this decision because there is not certainty that the machine will operate the way it’s supposed to. Future sales could dry up and leave the machine idle because there’s no demand for the product. It could also put a strain on the cash flow of the company.
All of these factors contribute to the risk of purchasing this new asset. Managers have to use financial ratios to help analyze the expected rate of return and see if it is worth taking the risk on the new purchase.
