The situation is akin to going on a road trip without a map while hoping to get to your destination without a clear picture of your financial future. Business risk management is essential for determining a clear course of action.
Utilizing financial ratios can be intimidating and confusing if you do not understand the technical aspects of business accounting. Become familiar with useful financial ratios before you start measuring business risk.
This article discusses five financial ratios that you can use to analyze your business risk profile and why you should measure it.
Why Measure Risk?
It is normal for business owners to know where they hope to go and what they want to achieve. A roadblock will stand in the way of your business and financial success.
Having an understanding of your business finances helps you avoid many risks. Expanding your business, acquiring another company, having low cash, increasing fixed expenses, and borrowing more money can all signal that it's time to reevaluate your business risk.
Why Do Financial Ratios Exist?
Financial ratios enable management, financial institutions, and stakeholders to evaluate the risks associated with a business. In addition to assessing a company's financial health, they also assess its market risk and its investment risk.
To determine the risk of selling a product or service, small business owners can rely on financial ratios. Small business owners are unaware of their finances to the tune of 60 percent, according to a study.
As a basis for establishing financial ratios, financial ratios are most useful to businesses already in existence, but they can also be helpful for consumers who want to start a business (by providing benchmarks and hypotheticals to determine the viability of an idea).
Business Risk Ratios
To evaluate business risk effectively, it is necessary to calculate a few key financial ratios. These ratios should help you evaluate your business and financial risk more effectively.
1. Gross Profit Margin
Contribution margin is the difference between sales and variable costs as a percentage of total revenue. Using the formula, you will be able to calculate the amount of income you need to cover fixed and variable costs and set profit targets for your business.
Sales / contribution margin = contribution margin ratio
Say your retail product is $20, but you have about $30,000 in fixed expenses (machinery, office expenses, interest on your loan). Labor and manufacturing costs per unit are $8.
- Estimate Your Contribution Margin:
- (Sales – Variable Costs) = ($25 – $8) = $17
- Calculate Your Contribution Margin Ratio:
(Contribution Margin/Sales) = ($17/$25) = 68 percent
According to the contribution margin ratio in this example, your fixed expenses are $30,000. 68 percent of sales can contribute to this amount. By estimating how many units it needs to sell each month, your business can now remain profitable.
2. Operational Leverage Effect (OLE)
Utilizing the operating leverage effect ratio, you can calculate your contribution margin ratio. A change in sales volume can be used to calculate the OLE ratio, which determines how much revenue is required to cover non-operating costs. If you need to adjust your prices, you need to know your company's potential profitability.
The ratio of operating margin to contribution margin
Let's say your business earned $1 million in revenue last year but operated at a cost of $300,000.
Your contribution margin can be calculated by applying the previous formula.
How much margin do you have? Let's calculate it:
(Revenue – Operating Costs)/Revenue = ($1 million – $300,000)/$1 million = 70 percent
By calculating your operating leverage effect ratio, you can determine how much of your cost is absorbed by variable expenses and how much by operations.
3. Leverage Ratio
A leverage ratio measures the overall risk of a financial institution. By comparing the amount of debt that your business holds to its income, you can estimate its financial risk.
Net income/operating income = financial leverage
The financial leverage ratio of the company with $3 million gross income, $2 million net income, and $2 million operating expenses would be calculated as follows.
- To begin, let's calculate your operating income:
(Gross Income – Operating Expenses) = $1 million
- Find your financial leverage:
(Operating Income)/(Net Income) = $1 million/$4 million = 25 percent
You could not take on more debt before your company's income increases, because your company is already in debt.
4. Ratio of Combined Leverage
Operational and financial leverage is typically calculated separately by most companies. As an alternative to calculating the two ratios individually, you can calculate the combined leverage ratio. You can use the ratio to get an idea of your overall risk by combining business and financial risk.
Leverage ratio = operating leverage x financial leverage
The total leverage ratio of your company is calculated by multiplying the operating leverage ratio and the financial leverage ratio. In the example, your business has no debt and financial leverage equals 80 percent:
(Operating Leverage Ratio) x (Financial Leverage Ratio) = (1) x (0.8) = 80 percent
A quick snapshot of your business and financial risk is provided. However, it does not provide a complete picture.
5. Leverage to Equity Ratio
Debt-to-equity ratios are typically used by banks and investors as risk indicators when they lend money to a company. Knowing the debt-to-capital ratio helps a business owner assess how resources are distributed and adjust their borrowing and spending accordingly.
Ratio of equity to debt = (total liabilities) / (shareholders' equity)
It's easy to calculate the balance sheet yourself if you don't have the corporate balance sheet. Interpretation is more important than calculation when determining this ratio.
Imagine you have $1,865,000 in total liabilities, including current and long-term obligations, and $620,000 in shareholders' equity. Do you have any debt?
(Total Liabilities)/(Shareholders’ Equity) = $1,865,000/$620,000 = 3.01
When your company has a high debt-to-equity ratio, it may be borrowing too much and unable to cover its expenses.
Ratios Help Manage Business Risk
There are many risks businesses face. Data from the Bureau of Labor Statistics shows that only 25 percent of startups survive 15 years or longer.
Using financial ratios to analyze your business risks and monitor the financial health of your company is a good idea. For instance, the contribution margin ratio, operational leverage ratio, financial leverage ratio, and combined leverage ratio all fit into this category. You will be able to get a clearer picture of various elements of your company's finances and potential risks by using each ratio.
