Risk and Leverage
Risk defined
Business risk is the exposure a company or
organization has to factor(s) that will lower its
profits or lead it to fail.
Anything that threatens a company's ability to
achieve its financial goals is considered a business
risk.
Operational Risk and Financing Risk
Operational Risk
Operational risk is the risk of losses caused by
flawed or failed processes, policies, systems or
events that disrupt business operations. Employee
errors, criminal activity such as fraud, and physical
events are among the factors that can trigger
operational risk.
Operational Risk
There are five categories of operational risk:
1. People risk – inadequacy of human capital and
management
2. Process risk – failed internal business processes
3. Systems risk - failed internal systems
4. External events risk - occurrence of external
events (natural and man-made events)
5. Legal and compliance risk - non-compliance with
internal and external regulations and laws
Operational Risk
Examples of operational risk:
A. Enterprise-wide interruptions, disruption or
failures
B. Reputational damage
C. IT infrastructure damage
D. Legal liability or regulatory fines
E. Competitive disadvantage
Financial Risk
Financial risk is a potential future situation that
causes your business to lose money. This situation
could affect your cash flow and leave you unable
to meet your obligations.
If you borrow a large amount of money to start or
run your business, you are more exposed to
financial risk than businesses with smaller levels of
debt.
Financial Risk
1. Market Risk
Market risk is largely caused by economic
uncertainties, which may impact the performance
of all companies and not just one company.
2. Credit Risk
This risk refers to the possibility that a creditor will
not receive a loan payment or will receive it late.
3. Liquidity Risk
It is possible that a company will not be able to
fulfill its commitments.
Measurement of Risk
Coefficient of Variation
The co-efficient of variation (CV) is a statistical
measure of the dispersion of data points in a data
series around the mean. The co-efficient of
variation represents the ratio of the standard
deviation to the mean, and it is a useful statistic for
comparing the degree of variation from one data
series to another, even if the means are drastically
different from one another.
Measurement of Risk
Coefficient of Variation
In finance, the co-efficient of variation allows
investors to determine how much volatility, or risk,
is assumed in comparison to the amount of return
expected from investments. Ideally, if the co-
efficient of variation formula should result in a
lower ratio of the standard deviation to mean
return, then the better the risk-return tradeoff.
Measurement of Risk
Coefficient of Variation
Formula:
𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑉 =
𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
Measurement of Risk
Coefficient of Variation
Suppose that we have three investments:
Measurement of Risk
Standard Deviation
Standard Deviation (SD) is a statistical measure
representing the Volatility or risk in an instrument. It
tells you how much the fund's return can deviate from
the historical mean return of the scheme. The higher
the SD, higher will be the fluctuations in the returns.
If a fund has a 12 percent average rate of return and
a standard deviation of 4 percent, its return will
Range from 8-16 percent.
Measurement of Risk
Standard Deviation
Formula:
Measurement of Risk
Standard Deviation
Example: Suppose we have an investment with the
following returns.
January (-1.11%) May (0.55%)
February (2.61%) June (2.22%)
March (4.24%)
April (5.24%)
Measurement of Risk
Example: Suppose we have an investment with the following
returns.
January (-1.11%) May (0.55%)
February (2.61%) June (2.22%)
March (4.24%)
April (5.24%)
Step 1: Find the Average Return:
(-1.11 + 2.61 + 4.24 + 5.24 + 0.55 + 2.22) / 6 = 2.29%
Measurement of Risk
Example: Suppose we have an investment with the following
returns.
January (-1.11%) May (0.55%)
February (2.61%) June (2.22%)
March (4.24%) Average Return: 2.29 %
April (5.24%)
Step 2: Find the difference of individual return to the average return,
the square it.
For January (-1.11 – 2.29)^2 = 11.56
For February (2.61 – 2.29)^2 = 0.10 …and so on.
Measurement of Risk
Example: Suppose we have an investment with the following
returns.
January (-1.11%) May (0.55%)
February (2.61%) June (2.22%)
March (4.24%) Average Return: 2.29 %
April (5.24%)
Step 3: Add all the results in step 2.
(11.56 + 0.10 + 3.80 + 8.70 + 3.03 + 0.0049) = 27.2%
this will be used as a numerator
Measurement of Risk
Example: Suppose we have an investment with the following
returns.
January (-1.11%) May (0.55%)
February (2.61%) June (2.22%)
March (4.24%) Average Return: 2.29 %
April (5.24%)
Step 4: Divide the numerator with the number of data points minus
1.
Numerator (27.20%) Data Points (6)
Therefore, (27.20%) / (6-1) =5.44%
Measurement of Risk
Example: Suppose we have an investment with the following
returns.
January (-1.11%) May (0.55%)
February (2.61%) June (2.22%)
March (4.24%) Average Return: 2.29 %
April (5.24%)
Step 5: Take the square root of the step 4.
Step 4: 5.44%
Squared: 2.33% (this is now your standard deviation)
Measurement of Risk
Standard Deviation
However, the standard deviation isn't
predictive. Instead, it tells you how volatile the
asset has been in the past.
An asset's standard deviation isn't enough to
tell you whether or not investing is a good idea. It's
also not predictive, as an asset's historical price
changes don't necessarily align with its future
returns. Still, it can be informative.
Leverage
This refers to the company’s strategy of using
creditors’ money in financing the organization’s
investing and operating activities. The more long
term debt is used, the more financially leveraged the
business is, and the higher the financial risk of the
business is.
Financial risk refers to the uncertainty of not meeting
future obligations as they mature due to the
inadequacy of assets or due to the critical level of
assets.
Leverage
Leverage is not necessarily bad. When revenues
are growing, payments are made with comfortable
surpluses and additional debt is acquired to take
advantage of market opportunities.
However, when revenues are low, a highly
leveraged business might fall behind on debt
payments and it might not be able to borrow
additional money to stay afloat.
Degree of Operating
Leverage (DOL)
Operating leverage refers to the ability of the
business to increase its profits in relation to its
contribution margin.
(Note: Profit refers to EBIT)
Formula:
DOL = Contribution Margin / EBIT
DOL = %change in EBIT / %change in Sales
Degree of Financial
Leverage (DFL)
Degree of Financial Leverage (DFL) quantifies the
sensitivity of a company’s net income (or EPS) to
changes in its operating profit (EBIT) as caused by
debt financing.
Formula:
DFL = EBIT / EBT
DFL = %change in NI / %change in EBIT
Degree of Total Leverage
(DTL)
The degree of total leverage (DTL) is a measure of
the sensitivity of net income to changes in unit
sales. This is the combination of DOL and DFL.
Formula:
DTL = DOL x DFL
Degree of Total Leverage
(DTL)
Revenue
(Variable Costs)
= Contribution Margin DOL
(Fixed Costs) DTL
= EBIT
(Interest) DFL
=EBT
Leverage
For Example:
Unit sales price P 200
Unit variable cost P 120
Total Fixed Cost P 550,000
Units Sold 10,000 units
Interest Expense P70,000
Find the DOL, DFL, and DTL.
Leverage
For Example:
Revenue (P200 x 10,000) P2,000,000
Variable Cost (P120 x 10,000) (P1,200,000)
Contribution Margin P800,000
Fixed Cost (P550,000)
EBIT P250,000
Interest Expense (70,000)
EBT P180,000
Leverage
For Example:
Revenue (P200 x 10,000) P2,000,000
Variable Cost (P120 x 10,000) (P1,200,000)
Contribution Margin P800,000
Fixed Cost (P550,000)
EBIT P250,000
Interest Expense (70,000)
EBT P180,000
DOL = (800,000) / (250,000) = 3.2
Leverage
For Example:
Revenue (P200 x 10,000) P2,000,000
Variable Cost (P120 x 10,000) (P1,200,000)
Contribution Margin P800,000
Fixed Cost (P550,000)
EBIT P250,000
Interest Expense (70,000)
EBT P180,000
DFL = (250,000) / (180,000) = 1.388888889
Leverage
For Example:
Revenue (P200 x 10,000) P2,000,000
Variable Cost (P120 x 10,000) (P1,200,000)
Contribution Margin P800,000
Fixed Cost (P550,000)
EBIT P250,000
Interest Expense (70,000)
EBT P180,000
DTL = 3.2 x 1.39 = 4.45
Thank you so
much!