# Calculate Business Risk Using These Financial Ratios

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Business risk is the variability that a business experiences over a specified time in its income. Some firms, like utility companies, have relatively stable income patterns over time. They can predict what their customer's utility bills will be within a certain range. Other types of business firms have more variability in their income over time. You can use these formulas to see how fixed costs, variable costs, sales, and debt will affect your business.

### Key Takeaways

• The contribution margin ratio shows you how much you can earn after covering variable costs and fixed costs.
• The degree of operating leverage shows you whether your business's variable or fixed costs are higher.
• The degree of financial leverage measures the amount of debt held by your business.
• The degree of total leverage shows you how much unit sales will affect the net income of your business.

## Product Demand and Business Risk

Another way to think about business risk is the demand for a company's product. Using the example of the automobile manufacturer again, in an economic downturn, consumers do not have as much demand for the companies' products. When product demand is low, that causes income to decline, and the business risk increases.

Business risk is tied to a company's fixed costs. Fixed costs always have to be paid, no matter what the company's income. The higher the level of a company's fixed costs, the higher the business risk.

There are four financial ratios that a business owner or financial manager can use to calculate the business risk facing a firm.

## Contribution Margin Ratio

The contribution margin ratio is the contribution margin as a percentage of total sales. The contribution margin is calculated as sales minus variable costs. The contribution margin ratio is calculated as:

• (Net Sales Revenue - Variable Costs ) / (Sales Revenue)

After you subtract the cost to make a product and the fixed costs of running the business, you're able to see how much you can earn per product.

## Degree of Operating Leverage

The degree of operating leverage, or DOL, is a financial efficiency ratio that measures whether a company's variable or fixed costs are higher.

• DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
• DOL = % Change in Operating Income / % Change in Sales
• Contribution Margin / Operating Income

A low DOL usually means that a business's variable costs are larger than its fixed costs, while a high DOL means that its fixed costs are higher than its variable costs. If variable costs are higher, then a large increase in sales will not lead to a substantial increase in operating income. However, the company will not need to budget for large fixed costs.

## Degree of Financial Leverage

In brief, the degree of financial leverage (DFL) measures the amount of debt held by the business firm. Debt creates an additional business risk to the firm if income varies because debt has to be serviced. In other words, if a firm uses debt financing, it has to pay interest on the debt no matter its income. We can also say that it measures the financial risk of the business firm.

The formula can be calculated in the following ways:

• DFL = % Change in Net Income / % Change in Earnings Before Interest and Taxes (EBIT)
• DFL = % Change in Earnings per Share (EPS) / % Change in EBIT
• DFL = EBIT / (EBIT - Interest)

If the ratio is 1.00, then the firm has no debt.

## Degree of Total Leverage

The formula for the degree of total leverage (DTL) calculates how much unit sales will affect the net income of your business or your business's net earnings per share. You can calculate the formula this way:

• DTL = DOL x DFL

This formula can also show you how much an increase in revenue should increase earnings per share.

## What Financial Ratios Are Used To Measure Risk?

You can measure your business risk using the contribution margin ratio, the operating leverage effect ratio, the financial leverage ratio, and the combined leverage ratio. These ratios use your business's fixed costs, debt, and sales to calculate business risk.

## What Is the Formula To Calculate Risk?

Risk can be calculated by multiplying the likelihood that the risk will occur and the potential severity of that risk. A formula that you can use to measure risk in any scenario is:

Risk = Likelihood x Severity