It’s like going on a road trip without a map and hoping to reach your destination without a clear financial picture. To determine a clear path forward, you have to effectively manage your business risk
When you don’t know the technical aspects of business accounting, using financial ratios can be intimidating and confusing. To begin measuring business risk, you should become familiar with helpful financial ratios.
Learn how to analyze your business risk profile with five financial ratios and why you should measure risk.
Risk Measurement: Why Measure it?
Business owners typically know what they want to achieve and where they want to go. The path to success will be impeded by financial and business obstacles.
You can often avoid risks by having a comprehensive view of your business finances. Even everyday business events like expansion, acquisition, low cash on hand, increased fixed expenses, and increased borrowing can signal that it is time to reevaluate your business risk.
Financial Ratios Used for?
A financial ratio helps executives, financial institutions, and stakeholders understand the risks associated with a company. They assess financial health, market risks, and risks associated with investing in a company.
For small business owners, financial ratios can be used to navigate the risks of selling a product or service. A study found that 60 percent of small business owners don’t know much about their finances.
Financial ratios are primarily useful for businesses already in existence, but they can also help consumers looking to start a business (by providing benchmarks and hypothetical to determine if an idea is a good one).
Ratios Used to Measure Business Risk
For effective risk measurement, a few key ratios must be calculated. To help you measure your business and financial risk better, I’ve put together this list of ratios.
1. Profit Margin
The contribution margin represents your contribution margin (sales – variable costs) as a percentage of the total. Your company’s profit targets are based on the formula to determine how much income is required.
Sales / contribution margin
Let’s say you have a $20 retail product and about $30,000 of fixed expenses, including machinery, office expenses, and loan interest. Each unit costs $8 in labor and manufacturing.
- First, calculate your contribution margin:
- (Sales – Variable Costs) = ($10 – $8) = $2
- Now, calculate your contribution margin ratio:
(Contribution Margin/Sales) = ($12/$20) = 60 percent
In this example, the contribution margin ratio indicates that 60 percent of sales for each product can contribute to your fixed expenses of $30,000. Your business can now easily estimate how many units it needs to sell each month to remain profitable. It can also be calculated using a profit margin calculator.
2. OLE (Operating leverage Effect)
You can analyze your contribution margin ratio using the operating leverage effect ratio. Using the OLE ratio, you can determine how much revenue is required to cover non-operating costs based on changes in sales volume. Knowing your company’s potential profitability can help you decide if you need to change prices.
OLE Ratio = Contribution Margin Ratio/operating Margin
Suppose your company earned $1 million in revenue last year, but it cost you about $300,000 to operate.
From the previous formula, you know what your contribution margin is.
Now let’s figure out your operating margin:
(Revenue – Operating Costs)/Revenue = ($2million – $300,000)/$1 million = 60 percent
Your operating leverage effect ratio can help you understand how much of your cost goes toward operations and how much has to be covered by variable expenses.
3. The Financial leverage Ratio
Leverage ratios measure financial risk overall. You can gauge your business’s financial risk level by comparing the debt held by your company with its income.
Financial leverage = operating income/net income
Financial leverage ratio would be calculated as follows if gross income, net income, and operating expenses each came to $3 million and $2 million.
- First, let’s calculate your operating income:
(Operating Expenses – Gross Income) = $1.5 million
- Next, find your financial leverage:
(Operating Income)/(Net Income) = $1 million/$4 million = 25 percent
It indicates that your company is already in debt and may not be able to take on additional debt before its income increases.
4. The Combined leverage Ratio
Most companies calculate operating and financial leverage separately. To compare the two ratios, you should also calculate a combined leverage ratio. The ratio combines business and financial risk to give you an idea of your total risk.
Financial leverage multiplied by operating leverage
The combined leverage ratio is simply the operating leverage ratio multiplied by the financial leverage ratio. Assuming your business has no debt and 80 percent financial leverage:
(Operating Leverage Ratio) x (Financial Leverage Ratio) = (1) x (0.8) = 80 percent
It doesn’t provide the complete picture, but it provides a quick snapshot of your business and financial risk.
5. Ratio of Debt to Equity
Banks and investors use the debt-to-equity ratio as a ratio of risk when lending money to an organization. Business owners must understand their debt-to-equity ratio to adjust spending and borrowing.
Debt-to-equity ratio = (total liabilities)/(shareholders’ equity)
If you don’t have your corporate balance sheet, you can calculate it yourself. The most important thing about this ratio is how you interpret it, not how you calculate it.
Say you have a total liability of $1,865,000, including current and long-term liabilities, and you have shareholders’ equity of $620,000. How much debt are you liable for?
(Total Liabilities)/(Shareholders’ Equity) = $1,865,000/$620,000 = 3.01
The debt-to-equity ratio can mean your company is borrowing too much and unable to keep up with its spending.
Managing Business Risk with Financial Ratios
Businesses face a variety of risks. Only 25 percent of new businesses survive 15 years or more, according to data from the Bureau of Labor Statistics.
Use financial ratios to monitor your company’s financial health and analyze your business risks. Some examples include the contribution margin ratio, operation leverage ratio, financial leverage ratio, and combined leverage ratio. Each ratio will allow you to gain insight into a different aspect of your company’s finances and potential risks.
