1. Corporate Financial Measures of Risk
Chapter 3
Corporate Financial Measures of Risk
Chapter 3

2. Chapter 3
Risk
Measures of Risk based on Accounting information as opposed to Risk measures based on financial markets (measures of risk determined by investors in the trading of financial assets in financial markets).
Liquidity – inverse measure of Risk
(measured by Current Ratio and Quick Ratio)
2. Credit Risk (Default Risk)
Times Interest Earned
Fixed Payment Leverage Ratio

3. Chapter 3
Risk
3. Operating Risk, operating leverage, business risk 4. Financial leverage

4. Operating Risk Financial accounting calculation:
Chapter 3
Operating Risk
Financial accounting calculation:
EBITDA = Sales – COGS – G&A
EBITDA = [GM/$]*Sales – G&A
GM/$ - Gross Margin per dollar Sales
G&A – General and Admin. Expenses

5. EBITDA = [CM/$]*Sales – FC
Chapter 3
Operating Risk
Managerial accounting calculation:
EBITDA = Sales – VC – FC
EBITDA = [CM/$]*Sales – FC
CM/$ - Contribution Margin per dollar Sales – is the contribution to the bottom line (EBITDA) from an incremental $ Sales.
Benchmark (N.A.) ~20%

6. Chapter 3
Operating Risk
Degree of Operating Leverage (DOL) is a measure of operating risk defined as:
1. Presume that primary and the sole source of Business Risk is Sales variability
2. This is elasticity

7. Degree of Operating Leverage
Chapter 3
Degree of Operating Leverage
Using managerial calculation for EBITDA:
So, DOL is the ration of two margins
DOL >= 1

8. Degree of Operating Leverage
Chapter 3
Degree of Operating Leverage
DOL is determined by a number of operating characteristics of firms:
CM/$ or CM/unit FC
Unit Sales
As a general rule anything that increases a firm’s ability to “cover” FC reduces DOL

9. Degree of Operating Leverage
Chapter 3
Degree of Operating Leverage
DOL:
Decreases with CM/$
Increases with FC
Decreases with unit Sales
EBITDA Margin:
Increases with CM/$
Decreases with FC
Increases with unit Sales
O.T.E. DOL and EBITDA Margin are inversely related.
Profitability & Risk – inversely related

10. Financial Leverage Debt: does not create Risk,
Chapter 3
Financial Leverage
Debt:
does not create Risk,
but it accentuate it for shareholders
Example:
Bad
Average
Good
ROIC 8%
12%
16%
probability
1/3

11. Financial Leverage ROE variability After tax ROIC ROE Bad year 4.8%
Chapter 3
Financial Leverage
IC = $3,000,000
Debt = $1,000,000
Equity = $2,000,000
ROE variability
After tax ROIC
ROE
Bad year
4.8%
4.2%
Average year
7.2%
7.8%
Good year
9.6%
11.4%

12. Financial Leverage ROE variability After tax ROIC ROE Bad year 4,8%
Chapter 3
Financial Leverage
IC = $3,000,000
Debt = $2,000,000
Equity = $1,000,000
ROE variability
After tax ROIC
ROE
Bad year
4,8%
2.4%
Average year
7.2%
9.6%
Good year
16.8%