Knowing what your risk exposure is vital to any company to help it make sound financial decisions. Business risk is associated with your fixed cost, these cost must be paid regardless of your income, thus the higher the cost, the greater the risk. To help measure your risk, you can use the following financial ratios:
1) Operating Leverage Effect (OLE) ratio - Measures the change in income due to change in sales. formula = contribution margin ratio / operating margin. (goal is OLE ratio =< 1)
2) Financial Leverage Ratio - Measure the amount of debt used to finance operations. formula = operating income / net income (goal is ratio =< 1)
3) Combined Leverage Ratio - Measures your business risk and financial risk combined. formula = operating leverage X financial leverage, (key higher the CLR, higher the risk)
4) Contribution Margin Ratio - Sales minus variable cost, profit or net income to fixed cost.
formula = contribution margin / sales = 1 - variable cost / sales.
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