The Portable MBA in Finance and Accounting, 4th Edition

15

Financial Management of Risks

Steven P. Feinstein

 

 

 

For better or worse, the business environment is fraught with risks. Uncertainty is a fact of life. Profits are never certain, input and output prices change, competitors emerge and disappear, customers’ tastes constantly evolve, technological progress creates instability, the economy may be volatile, and interest rates, foreign currency values, and asset prices fluctuate. Nonetheless, managers must continue to make decisions. Businesses must cope with risk in order to operate. Managers and firms are often evaluated on overall performance, even though performance may be affected by risky factors beyond their control. The goal of risk management is to maximize the value of the firm by reducing the negative potential impact of forces beyond the control of management.

There are essentially four basic approaches to risk management: risk avoidance, risk retention, loss prevention and control, and risk transfer.¹ Suppose after a firm has analyzed a risky business venture and weighed both the costs and benefits of exposure to risk, management chooses not to embark on the project. They determine that the potential rewards are not worth the risks. Such a strategy would be an example of risk avoidance. Risk avoidance means choosing not to engage in a risky activity because of the risks. Choosing not to fly in a commercial airliner because of the risk that the plane might crash is an example of risk avoidance.

Risk retention is another ...