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. For example, automobile manufacturers are very much tied to the state of the economy. If the economy is in a downturn, fewer people buy new cars and the income of automobile manufacturers drops and vice versa. Automobile manufacturers have more business risk than do utility companies.
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.
#1. 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:
- Contribution Margin/Sales = 1 - variable costs/sales
If a company's contribution margin ratio is 20%, then a $50,000 increase in sales will cause a $10,000 increase in profit. You can see the sensitivity of profit or net income to fixed costs in this example.
#2. Operating Leverage Effect – OLE Ratio
You use the operating leverage effect ratio to measure how much income will change given a percentage change in sales volume. The more fixed assets the firm has, the more the change will be. The formula for the operating leverage effect ratio is:
- Contribution Margin Ratio/Operating Margin
If the OLE is equal to 1, that means that the firm has no fixed costs. All costs are variable and a 20% change in sales volume will mean a 20% change in income. When you introduce fixed costs into the picture and the OLE rises above 1, then the firm has operating leverage.
Financial Leverage Ratio
In brief, the financial leverage ratio measures the amount of debt held by the business firm that they use to finance their operations. 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, they have to pay interest on the debt no matter what their income. The financial leverage ratio measures that affect the business firm. We can also say that it measures the financial risk of the business firm. The formula is:
- Financial Leverage = Operating income/Net income.
If the ratio is 1.00, then the firm has no debt.
Combined Leverage Ratio
Although business firms most often calculate operating leverage and financial leverage separately, they can and should also calculate the effect of both on the firm. They can use the combined leverage ratio to do this. You simply put together the operating leverage ratio, which measures business risk, and the financial leverage ratio, which measures financial risk, to get combined leverage, which measures total risk. The formula is:
- Combined Leverage Ratio = Operating Leverage Ratio X Financial Leverage Ratio
The higher the CLR, the riskier the business firm from both a business and a financial risk perspective. You can see by looking at the individual ratios which type of risk is greater for the firm.