It's comparable to taking a road journey without a map and attempting to get where you're going without having a clear financial picture. You must successfully manage your business risk if you want to decide a clear course of action.
Using financial ratios might be frightening and perplexing if you are unfamiliar with the technical components of corporate accounting. You should familiarize yourself with useful financial ratios in order to start calculating business risk.
Learn how to use five financial parameters to examine your company's risk profile and why measuring risk is important.
Risk Measurement: why Measure it?
Business owners frequently have clear goals and objectives in mind. Financial and commercial obstacles will stand in the way of achievement.
Having an extensive understanding of your company's finances might help you avoid several problems. Even routine business occurrences like growth, acquisition, limited liquidity, rising fixed costs, and increased borrowing can indicate that it is time to reassess your company's risk.
What are Financial Ratios Used for?
A financial ratio aids in the understanding of a company's risks by executives, financial institutions, and stakeholders. They evaluate a company's financial stability, market hazards, and investment-related risks.
Financial ratios can be used by small business owners to assess the risks involved in offering a good or service. According to research, just 60% of small business owners are financially literate.
Financial ratios are most helpful for firms that are already in operation, but they can also assist those wanting to start a business (by providing benchmarks and hypotheticals to determine if an idea is a good one).
Ratios Used to Measure Business Risk
To accurately assess business risk, it is necessary to calculate a few important financial measures. This list of ratios was put together by me to assist you in properly measuring your business and financial risk.
1. Profit margin
The contribution margin displays your contribution margin as a proportion of total revenue (sales minus variable costs). You can define profit goals for your company and determine how much income is needed to meet fixed and variable costs by using the formula.
Sales / contribution margin
Consider that you have a $20 retail product and around $30,000 in fixed costs, such as office costs, machinery, and loan interest. $8 is spent on labor and production for each item.
According to this example's contribution margin ratio, each product's sales can contribute 60% of your $30,000 in fixed expenses. Now that you know how many units your company needs to sell each month to stay profitable, you can estimate it with ease. A profit margin calculator can also be used to figure it out.
2. OLE (operating leverage effect)
Utilizing the operating leverage impact ratio, you can examine your contribution margin ratio. Based on changes in sales volume, you can use the OLE ratio to calculate how much revenue is needed to cover non-operating costs. It can be easier to decide whether to change prices if you are aware of your company's prospective profitability.
OLE ratio = contribution margin ratio/operating margin
You can learn how much of your cost is allocated to operations and how much must be paid by variable expenses by looking at your operating leverage effect ratio.
3. The Financial leverage Ratio
Overall financial risk is measured by leverage ratios. By contrasting your company's debt load with its revenue, you may determine the degree of financial risk that your organization faces.
Financial leverage = operating income/net income
Your financial leverage ratio would be determined as follows in the example above, where your gross income, net income, and operational expenses were each $3 million and $2 million.
It demonstrates that your company is currently in debt and might not be able to take on additional debt until its income increases.
4. The Combined leverage Ratio
The majority of businesses divide operating and financial leverage. You should additionally compute a combined leverage ratio in order to compare the two ratios. The ratio gives you an overview of your overall risk by combining business and financial risk.
Financial leverage multiplied by operating leverage
To get your company's combined leverage ratio, just multiply your operating leverage ratio by your financial leverage ratio. Assuming your company has no debt and financial leverage of 80%:
5. Ratio of debt to Equity
The debt-to-equity ratio is commonly employed as a risk indicator when banks and investors loan money to a firm. To evaluate the allocation of their resources and make required adjustments to their spending and borrowing, business owners must be aware of their debt to capital ratio.
Debt-to-equity ratio = (total liabilities)/(shareholders’ equity)
You can compute it yourself if you don't have access to your company's balance sheet. The how you understand this ratio, not how you compute it, is what matters most.
Consider that you have shareholders' equity of $620,000 and a total obligation of $1,865,000, which includes both current and long-term liabilities. How much debt do you have to pay back?
The debt-to-equity ratio may indicate that your business is taking on too much debt and is struggling to meet its obligations.
Managing Business Risk with Financial Ratios
Numerous dangers might affect businesses. According to data from the Bureau of Labor Statistics, just 25% of new enterprises survive for 15 years or more.
Financial ratios can be used to assess your company's risks and track its financial health. The contribution margin ratio, operation leverage ratio, financial leverage ratio, and combined leverage ratio are a few examples. You can learn more about many aspects of the finances and potential threats of your organization by using each ratio.
