For many small and medium sized businesses, most insurance underwriters will be able to determine the quality of risk by looking at a few key factors such as loss history, location, years in business, revenues, qualifications of management and accounting information if warranted. Yet for much larger and complex risks with revenues in the 10's of millions, ratio analysis has become mandatory. There are many types of ratios that can be derived from the accounting records. We will look at a few key ratios that assist insurers in identifying the following key objectives.
- The overall financial strength of the company
- The ability to pay premiums
- Growth and future shortcomings
I will examine 4 of the more common types of ratios used by underwriters and actuaries.
Total Assets Turnover Ratio
Leverage Ratio
Liquidity Ratio
Profitability Ratio
Total Assets Ratio- numbers from both the balance sheet and the income statement are needed to determine this ratio. The total assets turnover ratio helps determine the financial strength of the company and its ability to use assets to generate sales. It is often used in back to back year comparisons
Total assets turnover ratio = ____Sales______
Average total assets
Ex: MYcompany = 1,500,000 / ($ 960,000 + $ 1,000,000)
= 1.3
A ratio amount of less than 3 is a good indicator that there may be an issue with one or more of the asset categories such as fixed assets, inventory or account receivables. The insurer would most likely look into this further to seek out if there could be a problem with inventory or if the firm's collection period is too long.
Leverage Ratio – this ratio looks at the company's ability to meet its financial obligations. The larger the debt may be, the greater the chance that the company will be unable to meet their debt payments.
The most commonly used Leverage ratio is total debt to total assets and can be calculated as follows
Total debt to total assets ratio = ___Total debt___
Total assets
EX: Mycompany = $ 650,000 / $ 1,400,000
= .46
For each dollar of the company's assets, creditors are financing 46 cents. This is very close to 50% or 50 cents and should be monitored closely with calculations done on previous years to see how the company is trending.
Liquidity Ratio – this really quick ratio allows one to determine the company's ability to pay short term debts. A low ratio will indicate the company may be struggling and unable to meet expenses as they come due. A ratio amount of less than 2 is usually an indication of poor performance.
The most common liquidity ratio is the Current ratio calculation
Current ratio = __Current assets___
Current liabilities
EX: Mycompany = $ 130.00 / $ 48,000
= $ 2.7
Mycompany has $ 2.7 of Current Assets to meet $ 1.00 of its Current Liability. This is a good ratio.
Profitability Ratio – this ratio measures the overall performance of a company. The Net profit margin is the most easy and commonly used ratio. It quickly indicates how much of each dollar shows up as net income after all expenses have been paid. For example, if the net profit margin is 5% that means that 5 cents of every dollar is profit. A ratio amount of 5% or greater is a good indication.
Net Profit Margin = Net Income
Net Sales
EX: Mycompany = $ 45,000 / $ 560,000
= $ .084 or 8.4%
Thus Mycompany realized an 8.4% net profit after taxes.
Once a few or all of the above scenarios are run by the insurer, they can then determine if the risk presented fits their guidelines guidelines and what premiums and coverage's will be applied. If the risk is unfavorable, the insurer will most likely decline the risk and keep a record on file indicating this risk was presented and declined usually for a 3-5 year period. In addition to insurance companies, many banks have also run these formulas to help determine the efficiency of operations and credit worthiness of loan applications. These simple and quick calculations can provide instant information about a company's performance and can trigger alarming numbers that may need to be reviewed more closely. Small and medium sized business owners can do these calculations on their own or seek out an accountant to see how their business is trending before the year end income statement and balance sheet are produced.
It must be pointed out that different industries have different ratio benchmarks. Many insurance companies have gathered this information from many years of data from a number of different industries. An excellent place to obtain key business ratios is Dun and Bradsweet. Feel free to drop me a line if you have any questions or looking for other key ratio indicators.