As your business continues to scale and expand, it becomes more and more important to keep track of your business risk. But it can be tough to measure risk without keeping a close eye on a few key financial ratios.
Managing business risk without a clear financial picture is like going on a road trip without a map and hoping you’ll end up at your planned destination. When the business risk is effectively managed, you can determine a clear path forward according to your financial situation.
Using financial ratios can be intimidating and confusing if you don’t have a technical understanding of business accounting. Familiarizing yourself with helpful financial ratios to measure business risk is a great place to start.
Let’s take a closer look at why you should measure risk and how you can use five financial ratios to gain insights into your business risk profile.
Why measure business risk?
When you run a business, you typically know your destination and what you want to achieve. And there will be financial and business roadblocks that detour your path to success.
There are numerous instances where an in-depth view of your business finances can help avoid risks. Everyday business events such as expansion projects, acquisitions, low cash on hand, increased fixed expenses, increased borrowing, and even an increase in sales can be signs that it’s time to reevaluate your business risk.
There’s no room for gut feelings and leaps of faith in business. Business owners and managers must use financial ratios to manage business risk effectively and avoid financial setbacks.
According to a study by author Steve Martin, the number one quality of successful business people is resourcefulness. This list of financial ratios is an excellent resource for business owners who are ready to take their organization to the next level.
What do financial ratios measure?
Financial ratios are used to ensure that executives, financial institutions, and stakeholders have an accurate picture of risks associated with an organization. They measure different aspects of your company’s financial health for financial management, market risks, and risks related to investing in a company.
Financial ratios can also help navigate the risks of selling a particular product or service for small business owners. According to a study, 60 percent of small business owners admit that they don’t feel knowledgeable about their finances.
While financial ratios are primarily useful for those already in business, they can benefit someone looking to start a business as well (such as using benchmarks and hypotheticals to determine if an idea is viable or too risky).
Financial ratios to measure business risk
To effectively measure business risk, it’s crucial to calculate some key financial ratios. Here is a list of some commonly used ratios that can help you measure your business and financial risk to better manage the health of your organization.
1. Contribution margin ratio
The contribution margin ratio shows the contribution margin (sales – variable costs) as a percentage of your total sales. This formula will tell you how much income there is to cover fixed and variable costs and help your company set profit targets.
Contribution margin ratio = contribution margin / sales
For example, let’s say you have a product that costs $20 retail, and you have about $30,000 of fixed expenses, including machinery, office expenses, and loan interest. It costs about $8 for labor and manufacturing to make each unit.
1. First, calculate your contribution margin:
(Sales – Variable Costs) = ($20 – $8) = $12
2. Now, calculate your contribution margin ratio:
(Contribution Margin/Sales) = ($12/$20) = 60 percent
The result of this contribution margin ratio in this example tells us that 60 percent of the sales from each product is available to contribute to your $30,000 of fixed expenses. Now you can quickly determine how many units you need to sell each month to keep your business up and running.
In a perfect world, your contribution ratio would be 100 percent. But a good contribution margin is subjective and depends on how much your fixed expenses cost and the number of units you can sell in a given month.
2. Operating leverage effect (OLE) ratio
The operating leverage effect ratio can help you analyze your contribution margin ratio. Use the OLE ratio to measure how your income increases or drops depending on the changes in sales volume to show how much revenue is available to cover non-operating costs. This can help you decide if you need to change your prices and get a glimpse into your company’s future profitability.
OLE ratio = contribution margin ratio/operating margin
Let’s say that your organization earned $1 million in revenue last year, and it cost you about $300,000 to operate your business.
You already know your contribution margin ratio from the previous formula.
So let’s start by calculating your operating margin:
(Revenue – Operating Costs)/Revenue = ($1 million – $300,000)/$1 million = 70 percent
Calculating your operating leverage effect ratio can help you better understand how much of your costs are going towards operations and how much you have to cover variable expenses. A high OLE indicates a higher profit potential, while a low OLE shows low profitability potential.
3. Financial leverage ratio
The financial leverage ratio is used to measure overall financial risk. By measuring the amount of debt held by your company against its income, you can glean a picture of how investors see your business in terms of financial risk.
Financial leverage = operating income/net income
For example, if your gross income last year was $3 million, net income was $4 million, and your operating expenses added up to $2 million, this is how you would calculate your financial leverage ratio.
1. First, let’s calculate your operating income:
(Gross Income – Operating Expenses) = $1 million
2. Next, find your financial leverage:
(Operating Income)/(Net Income) = $1 million/$4 million = 25 percent
This value shows that your business has financial obligations and may not be ready to take on additional debt until your company can generate more income.
4. Degree of combined leverage ratio
Separately calculating operating and financial leverage is most common. Still, if you want to see how the two ratios relate to each other, you should also calculate a combined leverage ratio. This ratio measures business and financial risk in one balance to get an idea of your total risk.
Combined leverage ratio = operating leverage ratio X financial leverage ratio
To calculate your company’s combined leverage ratio, simply input your figures for your operating leverage ratio and financial leverage ratio and multiply to get your result. For this example, let’s say that your business has no debt and a financial leverage ratio of 80 percent:
(Operating Leverage Ratio) x (Financial Leverage Ratio) = (1) x (0.8) = 80 percent
It doesn’t give the entire picture, but it does provide a simple at-a-glance look at your business and financial risk.
5. Debt-to-equity ratio
Banks, financial institutions, and investors typically use the debt-to-equity ratio to determine the risk of loaning money to an organization. Knowing your debt to capital ratio is essential for a business owner to see the distribution of resources and adjust spending and borrowing as needed.
Debt-to-equity ratio = (total liabilities)/(shareholders’ equity)
You can find these values on your corporate balance sheet, or you can calculate them on your own. What’s more important than knowing how to calculate this ratio is interpreting it.
Let’s say your total liabilities, including current and long-term liabilities add up to $1,865,000, and your shareholders’ equity adds up to $620,000. Now, let’s determine your debt-to-capital ratio:
(Total Liabilities)/(Shareholders’ Equity) = $1,865,000/$620,000 = 3.01
The goal isn’t necessarily to have a low debt-to-equity ratio. It can be a sign that your allocation of resources isn’t optimized and could generate more revenue or spend less in certain areas. It could also show investors that your business is not taking advantage of growth opportunities.
However, a significantly high debt-to-equity ratio can mean that your company is borrowing too much and unable to keep pace with your spending.
Use financial ratios to manage business risk
There are numerous risks that business owners face. Data from the Bureau of Labor Statistics shows that only 25 percent of new businesses survive 15 years or more.
Keep track of the health of your business and gain insight into your financial and business risk using financial ratios such as contribution margin ratio, operating leverage effect ratio, financial leverage ratio, combined leverage ratio, and debt-to-equity. Each ratio will give you insight into another aspect of your company’s financials and potential risks.
Small business owners have to wear many hats, and it can be difficult to learn all the ins and outs of your finances. Learning how to calculate these financial ratios can help you manage business risks without extensive accounting knowledge.
Explore our Business Growth and Management Guide to learn how to leverage these financial ratios along with your business plan and financial forecasts to strategically grow your business.