It becomes more and more crucial to monitor your business risk as your company grows and scales. However, it can be challenging to assess risk without paying close attention to a few important financial ratios.
Without a clear financial picture, managing business risk is like driving without a map and hoping to arrive at your intended destination. If the business risk is properly controlled, you can choose a clear course of action based on your financial status.
If you don’t have a technical understanding of corporate accounting, employing financial ratios might be scary and complicated. It’s a good idea to start by being familiar with useful financial ratios for assessing business risk.
Contribution margin ratio
The contribution margin ratio displays the contribution margin as a proportion of your whole sales (sales minus variable costs). You can use this method to determine how much income is needed to pay both fixed and variable costs, as well as to assist your business in setting profit goals.
Contribution margin ratio = contribution margin/ sales
Your contribution ratio would be 100% in an ideal scenario. However, a healthy contribution margin is arbitrary and depends on how many units you can sell each month and how much your fixed expenses are.
Operating leverage effect (OLE)
You can examine your contribution margin ratio using the operating leverage effect ratio. In order to determine how much revenue is available to cover non-operating costs, use the OLE ratio to monitor how your income rises or falls in response to changes in sales volume.
This might give you insight into your company’s future profitability and assist you in determining whether price adjustments are necessary.
OLE ration = contribution margin ration/ operating margin
When OLE is high, there is a higher chance of making money; when OLE is low, there is a lower chance of making money.
Financial leverage ratio
To gauge general financial risk, one uses the financial leverage ratio. You may get a sense of how investors view your business in terms of financial risk by comparing the amount of debt it has to its income.
Financial leverage = operating income/ net income
This score demonstrates that your company has debt obligations and might not be prepared to take on further debt until it can increase revenue.
Degree of combined leverage ratio
The most typical approach is to calculate operating and financial leverage separately. However, you should also compute a combined leverage ratio to examine how the two ratios compare to one another. This ratio combines financial and business risk into one sum to give you an indication of your overall risk.
Combined leverage ration = operating leverage ratio X financial leverage ratio
Although it doesn’t reveal the whole picture, it can offer a quick snapshot of your company’s financial risk.
Debt-to-equity ratio
The debt-to-equity ratio is frequently used by banks, financial institutions, and investors to assess the risk associated with lending money to a company. For a business owner to understand the distribution of resources and modify spending and borrowing as necessary, knowing your debt-to-capital ratio is crucial.
Debt-to-equity ratio = (total liabilities)/(shareholders’ equity)
A big increase in your company’s debt-to-equity ratio may indicate that you are borrowing too much and are unable to keep up with your expenses.
This information is especially useful for small business entrepreneurs who have to do many things at a time, and understanding all the details of your finances can be challenging. Without having a deep understanding of accounting, learning how to compute these financial ratios can help you manage business risks.