Most insurance underwriters can determine the risk quality for small and medium-sized businesses by looking at key factors like loss history, location and years in business. Revenues, management qualifications and accounting information are all important. For complex risks, such as those with revenue in the tens of millions or more, ratio analysis is required. The accounting records can yield many different ratios. We’ll be looking at some key ratios that can help insurers identify the key objectives.
- The company’s overall financial strength
- Ability to pay premiums
- Future successes and growth
Let me show you four of the most common ratios used by actuaries and underwriters.
Ratio of total assets turnover
Ratio of Leverage
Liquidity Ratio
Ratio of Profitability
Ratio of Total Assets -numbers from both the balance sheet and the income statement are needed to determine this ratio. The company’s financial strength and ability to use its assets to generate revenue is determined by the total assets turnover ratio. This ratio is used to compare back-to-back years.
Total assets turnover ratio = ____Sales______
Average total assets
Ex: MYcompany = 1,000,000/ ($960,000 +$1,000,000)
= 1.3
A ratio less than 3 indicates that there is an issue with one of the asset types, such as inventory, fixed assets, or account receivables. This would be investigated by the insurer to determine if inventory is damaged or if the collection period is excessive.
Leverage Ratio – this ratio looks at the company’s ability to meets its financial obligations. The greater the company’s debt, the higher the likelihood that they will not be able to pay their debt payments.
The most popular Leverage ratio, which is equal to total debt to total assets, can be calculated in the following manner:
Total debt to total assets ratio = ___Total debt___
Total assets
EX: Mycompany = $650,000/$1,400,000
=.46
For every dollar of company assets, 46 cents are being funded by creditors. This figure is close to 50 or 50%. Creditors are financing 46 cents for every dollar of company assets. It is important to monitor the company’s trend with calculations made on previous years.
Liquidity Ratio – this really quick ratio allows one to determine the company’s ability to pay short term debts. A low ratio could indicate that the company might be in financial trouble and not able to meet its expenses. Poor performance is typically indicated by a ratio of less than 2.
The current ratio calculation is the most common liquidity ratio.
Current ratio = __Current assets___
Current liabilities
EX: Mycompany = $130,00/$48,000
= $ 2.7
Mycompany has $2.7 worth of Current Assets that can be used to pay $1.00 of its Current Debt. This is a great ratio.
Ratio for Profitability – this ratio measures the overall performance of a company. The most commonly used ratio is the net profit margin. It shows how much net income each dollar generates after expenses have been paid. If the net profit margin is 5 percent, that would mean that 5 cents per dollar is profit. An indication of good quality is a ratio greater than 5%.
Net Profit Margin = Net Income
Net Sales
EX: Mycompany = $45,000/$560,000
= $.084 / 8.4%
Mycompany thus realized an 8.4% net profit after taxes
After analyzing all or some of these scenarios, the insurer can determine if the risk presented meets their underwriting guidelines. If so, the insurer will apply the appropriate premiums and coverage. The insurer will likely decline the risk if it is not favorable. A record of this information will also be kept on file. This records usually lasts for between 3-5 years. Many banks also use these formulas to assess the creditworthiness of loan applications and determine the efficiency of their operations. These quick calculations can give you an instant picture of a company’s performance. However, they can also trigger alarming numbers that might need to be reviewed. You can either do the calculations yourself or hire an accountant to help you see where your business stands before the year-end income statement and balance sheets are generated.
