Thursday, October 06, 2011

Business Risk Ratios

CFA Level 1 - Financial Ratios

Business Risk - This is risk related a company's income variance. There is a simple method and more complex method:

Simple Method

The following four ratios represent the simple method of business risk calculations. Business risk is the risk of a company making less money, or worse, losing money if sales decrease. In the declining-sales environment, a company would lose money mainly because of its fixed costs. If a company only incurred variable costs, it would never have negative earnings. Unfortunately, all businesses have a component of fixed costs. Understanding a company's fixed-cost structure is crucial in the determination of its business risk. One of the main ratios used to evaluate business risk is the contribution margin ratio.
1.Contribution Margin Ratio
This ratio indicates the incremental profit resulting from a given dollar change of sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits.

                                                                                           Formula 7.28
Contribution margin ratio = contribution / sales
                                           = 1-(variable cost / sales)

2.Operation Leverage Effect (OLE)
The operating leverage ratio is used to estimate the percentage change in income and return on assets for a given percentage change in sales volume. Return on sales is the same as return on assets.

If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are variable, so a 10% increase in sales will increase the company's ROA by 10%.

                                                                                          Formula 7.29
Operation leverage effect = contribution margin ratio
                                                 return on sales (ROS)

Percentage change in income (ROA) = OLE * % change in sales

3.Financial Leverage Effect (FLE)
Companies that use debt to finance their operations, thus creating a financial  leverage effect and increasing the return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is used to quantify the effect of leverage within a company.

It is defined as:

                                                                                        Formula 7.30
Financial leverage effect = operating income / net income

If a company has an FLE of 1.33, an increase of 50% in operating income would result in a 67% shift in net income.

4.Total Leverage Effect (TLE)
By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as:

                                                                                               Formula 7.31
Total leverage effect = OLE * FLE

In our previous example, sales increased by $50,000, the OLE was 20% and FLE was 1.33. The total leverage effect would be $13,333, i.e. net income would increase by $13,333 for every $50,000 in increased sales.
Complex Method
Business risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time. A more structured approach is to use some statistics. One common method is to gather a date set that's large enough (five to 10 years) to calculate the coefficient of variation. 

With this approach: 

- Business risk = standard deviation of operating income / mean of operating income
- Sales variability = standard deviation of sales / sales mean
- Another source of variability of operating income is the difference between fixed and variable cost. This is referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1.
Look Out!

Note that it is unlikely that the exam will ask you to calculate any ratios relating to business risk that utilize statistics. 

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