What Is Risk?

The job of the financial manager is to maximize the value of the firm for the owners, or shareholders, of the

company. The three major areas of focus for the financial manager are the size, the timing, and the riskiness

of the cash flows of the company. Broadly, the financial manager should work to

• increase cash coming into the company and decrease cash going out of the company;

• speed up cash coming into the company and slow down cash going out of the company; and

• decrease the riskiness of both money coming in and money going out of the company.

The first item in this list is obvious. The more revenue a company has, the more profitable it will be.

Businesspeople talk about “top line” growth when discussing this objective because revenue appears at the

top of the company’s income statement. Also, the lower the company’s expenses, the more profitable the

company will be. When businesspeople talk about the “bottom line,” they are focused on what will happen to

a company’s net income. The net income appears at the bottom of the income statement and reflects the

amount of revenue left over after all of the company’s expenses have been paid.

The second item in the list—the speed at which money enters and exits the company—has been addressed

throughout this book. One of the basic principles of finance is the time value of money—the idea that a dollar

received today is more valuable than a dollar received tomorrow. Many of the topics explored in this book

revolve around the issue of the time value of money.

The focus of this chapter is on the third item in the list: risk. In finance, risk is defined as uncertainty. Risk

occurs because you cannot predict the future. Compared to other business decisions, financial decisions are

generally associated with contracts in which the parties of the contract fulfill their obligations at different

points in time. If you choose to purchase a loaf of bread, you pay the baker for the bread as you receive the

bread; no future obligation arises for either you or the baker because of this purchase. If you choose to buy a

bond, you pay the issuer of the bond money today, and in return, the issuer promises to pay you money in the

future. The value of this bond depends on the likelihood that the promise will be fulfilled.

Because financial agreements often represent promises of future payment, they entail risk. Even if the party

that is promising to make a payment in the future is ethical and has every intention of honoring the promise,

things can happen that can make it impossible for them to do so. Thus, much of financial management hinges

on managing this risk.