Uses of Financial Ratios in Risk Management: - Offer

USES OF FINANCIAL RATIOS IN RISK MANAGEMENT
–Offer a 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 with Caution.
–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.
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 Bond
Covenants – Purchase of fire insurance as collateral.
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 of
the Characteristics of Debt.
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.
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 Liabilities
Total 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.
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.
 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 an
organization carrying little debt.
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 Stock
Earnings 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 loss
on the value of the organization reflects shareholders confidence.
TOBIN ’s ‘Q’ Ratio.
Tobin’s Q = Market value of firm .

Replacement value of assets
Directly calculated on a firm’s financial statements.

In the estimation of Tobin’s 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 to
replace all its assets, using current Market prices.
Value of above 1.0 Reflects stockholders beliefs and franchise
value.
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 firms
whose value of Tobin’s 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.
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, and
4) 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 Revenues $ 1724
Cost of Raw Stock 349
Current Assets $ 681 Current $ 457
Payroll 748
liabilities
Depreciation 49
Property, Plant $ 486 Longterm $ 298
Interest 43
& equipments Debt
Other expenses 393
Other assets $ 116 Deferrals $ 71 Total expenses $ 1582
Earnings before Taxes on Income 142
Total assets $ 1283 Total liabilities $ 826
Income Taxes 47
Earnings from Continuing operations 95
Stockholder’s $ 457
equity Loss from discontinued operations (8)
Net earnings 87

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USES OF FINANCIAL RATIOS IN RISK MANAGEMENT

–Offer a Convenient way to Summarize Financial Condition and

Long Term Debt to Net worth

Long Term Debt to Net worth Ratio = Long Term Debt

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

Acid Test Ratio:-

Tobin’s Q = Market value of firm .

Directly calculated on a firm’s financial statements.

Summary of Balance Sheet Summary Earnings Statement

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