The term `Risk' refers to the possibility of something unpleasant happening or the chance of encountering loss or harm. In running the business a firm is exposed to various risks from within or outside the firm. The total risk associated with a firm can be broadly divided into two components, viz., business risk and financial risk. Business risk is the risk associated with the operation of the firm. It is inherent in the firm's investments. It arises out of fluctuation of the firm's expected return on total fund invested. Financial risk is the risk associated with the financing decision of the firm. It arises out of possibility of failing to meet fixed commitment or contractual obligation and possibility of fluctuation in income available to owners' equity.
So, financial risk exists if the firm uses fixed charge-bearing capital in its capital structure. There are several factors that affect the business risk of a firm such as firm-specific factors, industry-specific factors and economy-specific factors. Managerial competence, competitive position, labor relations, assets structure, etc., are common examples of firm-specific factors. Growth prospect of any specific product in an industry, role of trade union, any special status enjoyed by the industry, etc., are included in the category of industry-specific factors. Rate of inflation, recession, foreign exchange rate, governmental policy, etc., are the economy-specific factors which affect all sectors of the economy.
The company-specific factors are the internal factors and so these factors can be minimized to some extent by engaging more money and competent personnel. But industry-specific factors and economy-specific factors are external ones and, therefore, they are beyond the control of a particular firm. Business risk is generally treated as an unavoidable risk while financial risk is an avoidable one. |
