Risk is inherent in every business. A proverb says: No risk, no gain. Every business organization making an investment expects to get some returns in the future.
But future is uncertain and so are the expected returns. Due to uncertainty of the future, a realized return need not correspond to the expected return.
The possibility of variation of the actual return from the expected return is termed as risk. If the realized return corresponds to expected return exactly, say interest from a bank deposit, there would be no risk.
Risk arises where there is a possibility of variation between expectations and realizations with regard to an investment. It can be defined as ‘the potential for variability in returns’. In business, the decision maker has to estimate the future returns which depends on various factors such as volume of sales, price of raw materials, manufacturing costs, etc.
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These factors are also dependent on several other factors like inflation, economic policy of the government, etc. Therefore actual returns are bound to differ from estimated returns. Operation of any business always involves a certain amount of risk. Firms invest money in the hope of earning profit.
However due to uncertainty in the business environment they cannot earn expected profit and face loss. Hence the word risk is commonly associated with the probability of losses due to unforeseen circumstances and events; but in the context of financial management, risk has a wide connotation and a definite financial meaning.
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According to Khan and Jain the term risk is defined as ‘the variability in the actual returns emanating from a project in future over its working life in relation to estimated return as forecast at the time of the asset buying decision’.