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Running head: FINANCIAL RATIOS

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Financial Ratios
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FINANCIAL RATIOS

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Financial Ratios
Introduction

Accounting ratio refers to the relative magnitude of two numerical selected values that
have been extracted from enterprise’s financial statements within a certain given financial
period. Accounting ratio has significant impact in determining the financial position of the
corporation, used by financial analysts to compare strengths and weaknesses, determine market
prices and develop effective profit maximization strategies in order to attain a competitive edge
in the field of interest (Groppelli & Ehsan, 2000). Values to be used in calculating financial
ratios are obtained from balance sheets, income statements, statement of cash flow or statement
of changes in equity. Commonly calculated rations include but not limited to: liquidity ratios,
activity ratios, profitability ratios and market ratios among others. This article is addressing the
importance of certain financial ratios for corporate management and financial decision making
within a business enterprise.
Current Ratio
This is liquidity ratio used to gauge the ability of the company to cater for both short and
long term obligations. Current ratio considers current assets relative to the company’s total
liabilities (Groppelli & Ehsan, 2000). Therefore, current ratio is calculated from the formula:
current ratio=current assets/current liabilities. It forms concrete foundation of determining the
capacity of the company to pay debts and measure financial health status of the company. A
higher current ratio implies that the company has higher capacity of catering for its obligations
with minimal turbulences.
Quick Ratio

FINANCIAL RATIOS

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Quick ratio is also called acid test ratio, referring to the concrete process of measuring the
ability of an enterprise to meet its short term obligations (liabilities) (Williams et al. 2008) Quick
ratio is calculated by the formula: quick ratio= (cash+ marketable securities + accounts
receivable)/current liabilities. Financial managers rely on quick ratio to develop effective
strategies of dealing with stiff market competition and avoiding chances of the organization
becoming bankrupt. A higher quick ratio implies that the company has enough ability of
handling the short term liabilities. On the other hand, quick ratio below 1.0 implies that the
company is over-leveraged and it’s struggling to grow its sales, pay bills and collecting
receivables (Groppelli & Ehsan, 2000). Financial managers are able to develop effective
strategies of maximizing profits and be able to address issues of conflicting market forces.

Debt Equity Ratio
This is used to measure a company’s financial leverage which is calculated by dividing a
company’s total liabilities by its stockholder’s equity. Debt equity ratio is used to by financial
managers to determine how the company is using its current debt to finance its assets; being
relative to the value amount represented by shareholder’s equity. Debt equity ratio is calculated
by total liabilities/shareholders’ equity. A high debt equity ratio implies that the company is
aggressive in increasing its growth by use of debts. Financial decision making stakeholders
appreciate the fact that aggressive leveraging is indeed risk and there is need to develop effective
strategies of addressing nauseating prevailing economic environment within the corporation
(Williams et al. 2008). A higher ratio will compel financial managers to employ effective
revenue generation mechanisms to avoid prevailing business risks that the company is likely to
be affected.

FINANCIAL RATIOS

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Inventory Turnover Ratio

This is an efficiency ratio showing how an inventory is managed. It is used to measure
the number of times an inventory is turned or sold during a given financial period. Inventory
turnover ratio is essential in the sense that it is used in financial decision making to determine
performance of a business corporation. It is used to determine stock purchasing being done
within a given financial period. In the event that company has large amount of inventory, the
company is compelled to sell large amounts of the same acquired inventory to avoid chances of
incurring holding costs (Williams et al. 2008). Another concrete component of inventory
turnover ratio is sales. This is the candid component which requires that sales and purchasing
department within an organization have to work hard in order to ensure streamlined flow.
Inventory Turnover Ratio is calculated as follows: inventory turnover ratio=cost of goods
sold/average inventory.

Receivables Turnover Ratio
This is also called amounts receivable ratio, accounts receivable turnover ratio or debtor’s
turnover ratio. It is used to indicate the efficiency in which a firm is able to manage its credit
being issued to customers (Houston & Brigham, 2009). Due to time value of money, a firm is
likely to lose money if it takes more time to collect credit lacking interest rates. Financial
decision making process do rely on this ratio to determine the ability of the company operating
on cash basis, efficient means of collecting credit awarded to customers and determine if the
company has higher customer proportion within its departments. High receivables turnover ratio
implies that a company has strict policy of credit extension thus essential mechanisms of dealing
with customers who take long to pay their debts. On the other hand, low ratio implies the

FINANCIAL RATIOS

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conservative nature of the company’s policy thus needs to loosen its policies in order to improve
the business. A low ratio may suggest that a company has poor means of debt collection, bad
debt policy and bad customer relationship. Therefore, receivable turnover ratio is used to
determine whether company’s credit policy is hurting it or not.

Total Assets Turnover Ratio
This refers to the ratio of the value of the company’s sales/revenues to that of the assets.
Financial decision making process rely on this ratio to determine the efficiency of how the
company uses available assets to generate revenue. Asset Turnover ratio= sales or revenues/total
assets. High total assets turnover ratio implies that the company is performing well due to higher
revenue generation efforts (Houston & Brigham, 2009). The type of industry in which the
company is immersed tends to determine the total assets turnover ratio. Those firms in utilities
and telecommunication have lower total assess turnover ratio as compared to those consumer
staples.

Profit Margin (Net Margin) Ratio

This measures the amount of income that is earned in relative to each dollar of sales rated
by comparison of the net income and net sales of a company. Business creditors, investors and
financial managers use this ratio to determine the effectiveness of the company to convert its
sales into net income (David, 1972). For example, low profit margin indicates that company
expenses are high and there is need to have a flexible budget to cater for unnecessary expenses.
Profit margin ratio is calculated by taking net income divided by net sales.

Return on Assets Ratio

FINANCIAL RATIOS
This is concrete indicator of how profitable the company is relative to its assets. It is
calculated by dividing net income over total assets. It is essential in determining the amount of
capital being generated for those assets that have been invested. Therefore, return assets ratio is
important for financial management and being in the right position of enabling the company to
make informed decisions without incurring huge financial costs (David, 1972).

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FINANCIAL RATIOS

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References

David, F. J. (1972). Evidence on the Importance of Financial Structure. Financial Management.
Vol. 1, No. 2 (Summer, 1972), pp. 45-50. Published by: Wiley on behalf of the. Financial
Management Association International. Stable URL: http://www.jstor.org/stable/3665143

Groppelli, A. A.; Ehsan, N. (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 433.
ISBN 0-7641-1275-9.
Houston, J. F.; Brigham, E. F. (2009). Fundamentals of Financial Management. [Cincinnati,
Ohio]: South-Western College Pub. p. 90. ISBN 0-324-59771-1
Williams, J. R.; Susan, F. H.; Mark, S. B.; Joseph V. C. (2008). Financial & Managerial
Accounting. McGraw-Hill Irwin. p. 266. ISBN 978-0-07-299650-0.

FINANCIAL RATIOS

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Running head: CORPORATE FINANCE

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Corporate Finance
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CORPORATE FINANCE

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Is The Capital Structure Logic Of Corporate Finance Applicable To Insurers? Review And
Analysis by Jan Dhaene, Cynthia Van Hulle and Gunther Wuyts
This article define corporate finance as that concrete sector that deals with sources of
funding and capital structure of corporations, effective actions taken by organizational managers
to address conflicting issues within the organization and advanced tools used for proper
allocation of financial resources. It talks about key concern of corporate finance of maximizing
shareholder value through long and short term financial planning strategies of capital investment
such as investment banking.
The article talks about key issue in corporate finance such as choice between equity, debt
and provisions in financing an enterprise. The article provides general overview of the literature
on the capital structure of insurers and the impact of insurers to corporate management within
business organizations. The article gives concrete explanation as to why insurers focus so
strongly on individual financing as opposed to corporate financing.
The article provides general knowledge on the importance of being aware about the
candid role of insurers in the economy especially the corporate world. Some of the factors that
contribute to stability of insurers comprise of solvency among other important factors. The
article discusses various capital structure theories and how they influence the entire process of
corporate finance in financial sectors of the economy. Examples of such theories are trade off
theory in corporate finance and the pecking order theory in corporate finance.
The article defines the concrete structure of the insurer such as insurer’s balance sheet,
both financial and debt technical provisions and insurance based trade off theory. Other
significant issues addressed are the pecking order and technical provisions versus equity and how

CORPORATE FINANCE
they determine exact environmental conditions within a certain industry. The article gives
empirical evidence to support various corporate finance theories. It also addresses interactions
between capital and business structure in the insurance sector. The article makes
recommendations on what ought to be done in order to streamline the insurance sector.

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CORPORATE FINANCE

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Reference

Jan, D., Cynthia, V. H. & Gunther, W. (2017). Is The Capital Structure Logic Of Corporate
Finance Applicable To Insurers? Review And Analysis. Journal of Economic Surveys.
doi: 10.1111/joes.12129


Value
total current assets
total liabilities
total assets
stock holders equity
total liabilities &equity
current liabilities
inventory
cost of goods sold
revenue
net income
net sales
acounts recevables
cash
marketable securities

2015 IBM Financial Ratos:
amount
financial ratio
$42,504,000.00 current ratio
$96,233,000.00 Quick Ratio
$110,495,000.00 Debt Equity Ratio
$14,262,000.00 Inventory Turnover Ratio
$110,495,000.00 Receivables Turnover Ratio
$34,269,000.00 Total Assets Turnover Ratio
$1,551,000.00 Profit Margin (Net Margin) Ratio
$41,927,000.00 Return on Assets Ratio
$81,741,000.00
$28,554,000.00
$38,072,000.00
$28,554,000.00
$7,686,000.00
$508,000,000.00

Source- http://www.nasdaq.com/symbol/ibm/financials?query=balance-sheet

value
124.03%
1588.14%
674.75%
674.75%
2703.22%
73.98%
75.00%
25.84%

ry=balance-sheet


doi: 10.1111/joes.12129

IS THE CAPITAL STRUCTURE LOGIC OF
CORPORATE FINANCE APPLICABLE TO
INSURERS? REVIEW AND ANALYSIS
Jan Dhaene, Cynthia Van Hulle and Gunther Wuyts
Faculty of Economics and Business
Department of Accountancy, Finance & Insurance
University of Leuven
Frederiek Schoubben*
Faculty of Economics and Business, Financial Management
University of Leuven
Wim Schoutens
Faculty of Science, Department of Mathematics
University of Leuven
Abstract. Since the financial crisis of 2008, next to banks, insurers have received increasing attention
from researchers and regulators because of their crucial role in the financial system. A key point for a
stable insurer is its capital structure, i.e. the choice between equity, debt and provisions in financing
its operations. Based on earlier work a quickly developing literature has directly applied capital
structure theories (in particular trade-off and pecking order) from corporate finance to insurers’
financing choices. Corporate finance concepts used herein however, are developed for industrial
firms. In this paper we provide an overview of the literature on the capital structure of insurers,
but contribute by systematically clarifying how to account for the specificities of insurers when
transferring the trade-off and pecking-order logic from an industrial to an insurer context. This way,
we add several new insights on an insurer’s choice between equity, financial debt and provisions.
In particular, we are able to explain why, as compared to industrial firms, insurers use less financial
debt, and why insurers focus so strongly on self-financing. Finally, we identify multiple avenues for
future research.
Keywords. Capital structure; Insurance; Pecking order theory; Trade-off theory

1. Introduction
Ever since the financial crisis, next to banks, the awareness of the role of insurers in the economy has
intensified. It is widely accepted that insurance firms contribute to economic growth by the efficient
distribution of risks through risk transfers while they add to financial stability by providing long-term
∗ Corresponding

author contact email: frederiek.schoubben@kuleuven.be; Tel: +32 16 32 64 62.

Journal of Economic Surveys (2017) Vol. 31, No. 1, pp. 169–189

C 2015 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden,
MA 02148, USA.

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DHAENE ET AL.

financial resources to the economy (e.g. De Weert, 2011; Insurance Europe, 2014; Swiss Re, 2014). Swiss
Re (2014) reports that in 2013 premiums written worldwide amounted to approximately 4.6 trillion US
dollars representing about 3621 US dollars per person in the developed markets and 192 US dollars per
person in the emerging markets. Their investments in financial assets amounted to approximately 27
trillion US dollars, or, in terms of magnitude, about 37% of worldwide GDP. The European insurance
industry represents 35% of worldwide market share in terms of premiums, followed by the US with 30%
market share (Insurance Europe, 2014).
An important element contributing to the stability of an insurer is its solvency. Not surprisingly,
since the financial crisis there is heightened interest in this topic. A quickly growing strand of academic
literature focuses on applying corporate finance capital structure theories to insurance companies. In fact,
following the publication of Miller and Modigliani’s (1958) capital structure irrelevance theorem, a lot
of research attention in Finance has been devoted towards the explanation of the choices firms make
in financing their operations, that is, their capital structure. While the existing empirical literature for
non-financial firms is abundant, until recently insurance companies (and banks) are often left out of the
discussion (Cheng and Weiss, 2012). Although the effort of translating corporate finance concepts – that
were developed for industrial companies – to insurance firms has contributed to our understanding of the
forces that shape insurer solvency, the arguments are usually scattered across different studies and remain
incomplete.
In this paper we review the latter literature and simultaneously develop several new insights on insurer
capital structure by bringing together scattered arguments and linking them systematically to those in
corporate finance. As our review necessarily brings together several strands of literature, we split up
our analysis in several steps. First, we recall the logic of the static trade-off and pecking order capital
structure theories in corporate finance. After providing information on the typical business model of an
insurance firm, we review the theoretical literature as well as the empirical research on the applicability
of the corporate finance logic to the insurance industry. By systematically exploring the link with
corporate finance capital structure theories, we clarify a number of phenomena within an insurer’s capital
structure that are observed and documented in the insurance literature but are usually merely attributed to
the deviating business model of the insurance industry. Specifically, we are able to explain why, as
compared to industrial firms, insurers use less financial debt. In fact researchers in insurance management
tend to ignore financial debt altogether and focus entirely on provisions and capital (see e.g. Doff, 2011;
Cheng and Weiss, 2012). Next, in a similar vein our arguments further clarify why insurers focus so
strongly on self-financing in practice. In line with the insurance literature, our logic also suggests that
relative to industrial firms, capital structure choice in insurance firms is likely to be more complex in
the sense that some relationships are more strongly driven by endogeneity while some extra costs and
benefits have to be taken into account. We further explore these latter complexities by reviewing several
sub-literatures focusing on the interactions between capital structure and insurer business plans (i.e.
investment decisions), risk exposure versus capital structure, reinsurance versus capital structure and
underwriting cycles.
The remainder of this paper is organized as follows. The second section provides an overview of
corporate finance theories. Section 3 provides a discussion of how these corporate finance theories on
capital structure are applicable to the special setting of insurance companies. Next, Section 4 addresses the
typical interactions between capital structure and business plans within the insurance industry. Section 5
concludes and discusses some avenues for future research in insurance management.

2. Capital Structure Theories
The choice of capital structure (i.e. the way firms finance themselves) has been a main topic of research
in corporate finance. Although some considerable disagreement remains, many important insights on
Journal of Economic Surveys (2017) Vol. 31, No. 1, pp. 169–189

C 2015 John Wiley & Sons Ltd

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the subject have been gained. Building on the seminal work by Miller and Modigliani (1958), a huge
literature that tries to explain capital structure choices has emerged. Elaborate surveys can be found in
Harris and Raviv (1991), Myers (2001) and Frank and Goyal (2008) among others. The major part of this
debate revolves around the trade-off theory and the pecking order theory.1 Below we briefly discuss these
theories, which are developed from the perspective of a typical industrial company. Nevertheless, as we
will see below, by going back to the foundations of the logic and applying these to insurers, relative to
the literature, extra insights are gained.

2.1 Trade-Off Theory in Corporate Finance
The trade-off theory is built on the assumption that firms pursue an optimal target financial mix that trades
off the marginal benefits and marginal costs of leverage. The starting point is the logic of Miller and
Modigliani (1958) that was originally developed presuming that firms operate in perfect capital markets,
but which was afterwards adjusted to take into account market imperfections as well as agency costs.
Specifically, and this was fundamental, in their 1958 article Miller and Modigliani separate investment and
financing decisions. They achieve this by taking the industrial investment decisions of a firm as given (i.e.
predetermined) so that the capital structure is determined in a next stage. However, once the industrial
investments are fixed (including also managerial effort), the cash fl...