Financial_Ratio_s

8/7/2019 Financial_Ratio_s

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USES OF FINANCIAL RATIOS IN RISK MANAGEMENT

Offera Convenient way to Summarize Financial Condition and

Compare Performance.

Helps Risk Manager to determine Retention Limits as they reflect

available Resources to reimburse Losses.

Offers guide to replacement of Assets.

When based on Accounting data, should be interpreted withCaution.

Leverett Observes

Materiality as a major concern

Materiality is any thing an outsider making a financial decision

would regard as improper The Possibility of a financial event like Retained Loss could be

deemed as material.

Require explanatory note in financial statements.

Finance officers do not like notes.


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Finance Ratios that can be directly related to

constraints on a Risk Managers Actions.

Leverage Ratios:

Measures the extent to which an organization is in debt.

Debt is a fixed obligation.High Level of debt - any change in earnings get

magnified.

High Leverage is likely to limit Risk Management

flexibility in other ways usually impose BondCovenants Purchase of fire insurance as collateral.


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Commonly used Leverage Ratios

Long Term Debt to Net worth

Long Term Debt to Net worth Ratio = Long Term Debt

Net worth

A 1:1 ratio implies equal amount of Debt and equity.

Includes P.V. of Payments under Long Term Leases Because

they represent a fixed Long Term Commitment with many ofthe Characteristics of Debt.


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Another measure of Leverage is the Times

interest earned Ratio.

Times interest earned = Earnings before Interest and Taxes + Depreciation

Interest

Measures the extent to which interest payments are met

from cash generated in an organizations operations.A High Ratio reflects Substantial Cushion

Earnings can decline Substantially without necessarily

impairing ability to meet fixed interest payments.

A Ratio of 12.0 implies, interest payments could still be met,

if cash generated from operations decline to 1/12th of the

Current level.


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Liquidity Ratios.

Measure the extent to which an organization can raise cash particularly in the

Short Run.

Refers to ease with which an asset can be converted into cash.

An organization Current Assets are assets that are likely to turn into cash

shortly.

Current Liabilities, obligations to be met in the near future.

Net working capital = Current Assets - Current Liabilities.Represents an upper limit to internally generated cash available to finance

unexpected short-term development.

Commonly used measure of liquidity

Ratio of Net working capital to total Assets

Current Assets Current LiabilitiesTotal Assets

If the value of this ratio is 0.5 expects to generate enough cash in the near future

to finance normal operations, provides for a margin of 5% of total Assets ( Book

Value)

This Contingency Margin could be used to finance unexpected Losses.


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Second measure of Liquidity.

Current Ratio = Current Assets .Current Liabilities

A ratio of 1.0 indicates cash conversion in the near future are just sufficient to

meet short term Liabilities.

Ratio < 1.0 indicates outside financing ( Borrowing)

Ratio > 1.0 indicates operations will generate a cash surplus in the near future.

Inventory includes current assets which are less marketable than widely traded

securities and amounts owed to the organization by customers.

Acid Test Ratio:-

More stringent test of Liquidity based on these marketable assets excluding

accounts receivable out the calculation.

Acid Test Ratio = Cash + Marketable Securities + Accounts Receivables

Current Liabilities.


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None of this Liquidity ratios capture an

organizations borrowing capacity. Apart from capacity to absorb retained losses risk

manager considers the willingness of Lenders to

provide needed funds.

This information is provided in the leverage ratios

described above.

Other things being equal lenders are less willing to

Lend to a heavily indebted organization than to anorganization carrying little debt.


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Market Valuation Ratios :-

Capture the reaction of stock holders to actions of managers.

The P.E. Ratio is commonly used to measure stock holders

valuation of an organization earnings.

P.E. Ratio = Market Price of Common StockEarnings per share.

A high P.E. Ratio is usually regarded as a sign of stockholders

beliefs that the organization earnings will grow at a high rate.

Assuming this belief is correct, the effect of an un issued losson the value of the organization reflects shareholders

confidence.


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TOBIN s Q Ratio.

Tobins Q = Market value of firm .

Replacement value of assets

Directly calculated on a firms financial statements.

In the estimation of Tobins Q, All amounts are marked to

their market value.

Includes all of its debts, and equity priced at market value.

Replacement value is what would cost the organization toreplace all its assets, using current Market prices.

Value of above 1.0 Reflects stockholders beliefs and franchise

value.


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Offers a measure of an organization incentive to

Invest.

Used to predict gain and losses in take over attempts.

From R.M. Point of view one would expect to see

active loss control and crisis planning efforts at firmswhose value of Tobins Q is > 1.0.

If the Ratio is < 1.0 , it may be content to abandon an

asset following damage, as the implied market value

of restoration appears to be less than the cost.


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Use the data in financial statements appearing below to calculate.1) The long term debt to Networth Ratio

2) The times interest earned Ratio.

3) The ratio of net working capital to total assets, and4) The current Ratio. Briefly explain the significance of each

Ratio to a Risk Manager.

Summary of Balance Sheet Summary Earnings Statement

( $ Millions ) ($ Millions )

Assets Liabilities

Current Assets $ 681 Current

liabilities

$ 457

Property, Plant

& equipments

$ 486 Longterm Debt $ 298

Other assets $ 116 Deferrals $ 71

Total assets $ 1283 Total liabilities $ 826

Stockholders

equity

$ 457

Revenues $ 1724

Cost of Raw Stock 349

Payroll 748Depreciation 49

Interest 43

Other expenses 393

Total expenses $ 1582Earnings before Taxes on Income 142

Income Taxes 47

Earnings from Continuing operations 95

Loss from discontinued operations ( 8 )

Net earnings 87

Financial_Ratio_s

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