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 CostsDOL = % Change in Operating Income / % Change in SalesContribution 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 EBITDFL = 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. Risk = Likelihood x Severity
