Hello and welcome to Corporate Finance Essentials for the CFA.
I'm Professor Michael McDonald.
Today, I'd like to talk to you about
the corporate finance essentials piece in the CFA exam.
Now, one of the key elements in running a business, any business,
is understanding the risks that go into that firm,
being able to manage those risks appropriately.
Risk analysis essentially measures the uncertainty in a firm's income.
So we might look at how a firm's income fluctuates over time,
and then we can gauge the level of riskiness in those income sources.
Basically, we can break down that risk into two different sections;
business risk and financial risk.
Business risk is essentially the uncertainty around the operating income for a company,
and it comes from volatility in sales,
production costs, things like that.
We measure business risk based on sales volatility,
operating leverage, and then the business risk itself.
In contrast, financial risk is the additional volatility of equity returns,
it's caused by a firms use of debt.
Financial risks could be measured using balance sheet ratios.
Financial risk is really driven by
the financial statements and the information report there,
where business risk is more tied to the fundamentals of the underlying company.
Let's go through each of these calculations just so that we make sure we understand.
The business risk calculation is based on
coefficient of variation in a company's operating income over several years.
Said differently, business risk is just equal to
the standard deviation of a measure like EBIT,
Earnings Before Interest and Taxes,
divided by our average, or mean EBIT.
Our sales risk is a function of sales volatility.