Financial Ratios  Business Risk Ratios
Business Risk  This is risk related a company's income variance. There is a simple method and more complex method:
I. 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 decliningsales 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 fixedcost 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 = contributionÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â sales Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â = 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 Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â return on sales (ROS)
Where: 
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.
Formula 7.30
Financial leverage effect = operating incomeÂ Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â 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 = OLEÂ x 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.
II. 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.
Note that it is unlikely that the exam will ask you to calculate any ratios relating to business risk that utilize statistics. 

Investing
Operating Leverage Captures Relationships
Find out how fixed and variable costs interact to shed new light on old companies. 
Fundamental Analysis
The Operating Leverage And DOL
Operating leverage tells investors about the relationship between a company's fixed and variable costs. The higher a company's fixed costs in relation to its variable costs, the greater its operating ... 
Professionals
Operating Profitability Ratios
CFA Level 1  Operating Profitability Ratios. Operating profitability looks at two forms of ratios. This section covers the return on sales measurements, such as EBITA and profit margin. 
Professionals
Operating Leverage and its Effects on a Project's Expected Rate of Return
CFA Level 1  Operating Leverage and its Effects on a Project's Expected Rate of Return. This section outlines the effects of operating leverage on a project's expected rate of return, ... 
Investing
Understanding The Leverage Ratio
Learn more on how the leverage ratio is used to calculate a company's ability to meet financial obligations and how changes in output will affect operating income. 
Economics
Calculating Operating Ratio
An operating ratio compares a companyâ€™s operating expenses to its net sales. 
Investing Basics
The Optimal Use Of Financial Leverage In A Corporate Capital Structure
The amount of debt and equity that makes up a company's capital structure has many risk and return implications. 
Investing Basics
Contribution Margin
Contribution margin is a cost accounting concept that allows a company to determine the profitability of individual products. 
Credit & Loans
Debt Ratios: The Debt Ratio
By Richard Loth (Contact  Biography)The debt ratio compares a company's total debt to its total assets, which is used to gain a general idea as to the amount of leverage being used by a company. ... 
Economics
Financial Leverage In Corporate Capital Structure
Corporate management uses financial leverage to increase earnings per share and returnonequity.

Operating Leverage
Operating leverage is a measurement of the degree to which a ... 
Degree Of Operating Leverage  ...
A type of leverage ratio summarizing the effect a particular ... 
Leverage Ratio
Any ratio used to calculate the financial leverage of a company ... 
Degree Of Combined Leverage  DCL
A leverage ratio that summarizes the combined effect the degree ... 
Leverage
1. The use of various financial instruments or borrowed capital, ... 
Variable Cost Ratio
Variable costs expressed as a percentage of sales. The variable ...

What are the risks of having both high operating leverage and high financial leverage?
In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their ... Read Answer >> 
Besides operating leverage, what are other important forms of leverage for businesses?
Learn about what other forms of leverage exist for businesses besides operational leverage, and the primary leverage metrics ... Read Answer >> 
What is the difference between operating leverage and financial leverage?
Discover the two equity valuation metrics, operating leverage and financial leverage, how they are similar and what differentiates ... Read Answer >> 
What is the relationship between degree of operating leverage and profits?
Find out why a company's degree of operating leverage is an important consideration when predicting future operating income ... Read Answer >> 
How can a firm bring down its operating leverage?
Discover how to determine a company's operating leverage and how this metric can be helpful to analysts and investors when ... Read Answer >> 
How does operating leverage affect business risk?
Learn how operating leverage affects business risk and how companies measure it. Review a relevant example of operating leverage ... Read Answer >>