What is a good liquidity ratio for an insurance company?

7.02.2020
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Introduction

In another blog, we have already discussed the liquidity ratio for an insurance company and how we can measure it. The liquidity ratio of a company shows the ability of a company to turn its assets into cash. This ratio is used to compare the financial performance of insurance companies and also used to determine how profitable a company is from year to year. Investors and creditors use this ratio to observe the potentiality of an insurance company before investing in it. In this blog, we will discuss a little more about the liquidity ratio and what liquidity ratio is good for an insurance company.

The liquidity ratio of an insurance company includes several more ratios, which come into play while checking how a company sounds financially. Following are the ratios that come under this ratio:

  1. Current Ratio
  2. Acid Test Ratio or Quick Ratio
  3. Absolute Liquidity Ratio
  4. Basic Defense Ratio

Let us take a closer view of these ratios and also their effect on insurance companies one by one.

1. Current Ratio

This ratio is a type of liquidity ratio that measures the financial strength of a company. Generally, we take 2:1 as an ideal liquidity ratio for an insurance company but it may vary from company to company. The formula for current ratio is :

Current ratio = Current Assets/ Current Liability

Where,
Current assets = Stock + Debtor + Cash in bank + Receivables + Loan and advances
Current liability = Creditor + Short-term loan + Bank overdraft + Outstanding expenses

The current ratio for a company below 1 means that the company’s debts due in a year or less are greater than its assets. Theoretically, the higher the current ratio, the more capable a company is of paying its obligations because it has a bigger part of short-term asset value corresponding to the value of its short-term liabilities. However, it can be said, a ratio over 3 indicates that the company can cover its current liabilities three times. It may also indicate that the company is not using its current assets efficiently, or is not managing its working capital.

2. Acid Test Ratio or Quick Ratio

The quick ratio or the acid test ratio of a company indicates the short-term liquidity position of the company. This ratio is a measure of a company’s ability to meet its short-term obligations with its most liquid assets. Since an acid test is a quick test to demonstrate the instant result of a chemical, therefore, Quick ratio is also called the Acid test ratio.

The Formula for the Quick Ratio Is:

QR = (CE + MS + AR) ÷ CL
OR
QR = (CA – I – PE) ÷ CL

where:
QR = Quick ratio
CE = Cash & equivalents
MS = Marketable securities
AR = Accounts receivable
CL= Current Liabilities
CA = Current Assets
I = Inventory
PE = Prepaid expenses

The normal Quick Ratio for a company is 1. As 1 resultant for the quick ratio of a company shows that the company is fully equipped with exactly enough assets to pay off its current liabilities. A company with a quick ratio of less than 1 may not be able to pay off its current liabilities in the short term, while a company having a quick ratio of more than 1 shows that the company can instantly get rid of its current liabilities. For example, a quick ratio of 1.5 for an insurance company shows that the company has $1.5 of liquid assets (that can easily be converted into cash within a short amount of time) available to cover each $1 of its current liabilities.

3. Absolute Liquidity Ratio

The absolute liquidity ratio of a company shows a relationship between the absolute liquid assets and current liabilities of the company.
The formula for Absolute Liquidity Ratio is :

Absolute Liquidity Ratio = Absolute Liquid assets ÷ Total Current Liabilities
Absolute Liquid assets for a company = cash in hand + cash at bank + marketable securities temporary investments
The optimum value of the Absolute Liquidity Ratio for a company is 1:2. This optimum ratio indicates the sufficiency of the 50% worth absolute liquid assets of a company to pay the 100% of its worth current liabilities in time. If this ratio for a company is relatively lower than 1, it shows the company’s day to day cash management in a poor condition.

4. The basic Defense Ratio

The basic Defense Ratio also called the Defensive Interval Ratio (DIR), is the most commonly considered liquidity ratio. It indicates the number of days an organization can operate without access to its noncurrent assets. The basic defense ratio is sometimes viewed as the financial efficiency ratio of a company.

The formula for the basic defense ratio is:
Basic Defense Ratio = Total current assets ÷ daily operational expenses
where:
Total Current assets = cash + marketable securities + net receivables
Daily operational expenses = (yearly operating costs – noncash charges) / 365

The higher the defensive interval ratio the more days a company can operate in terms of meeting daily operational expenses without running into any financial difficulty, that would likely not require to access its additional funds.

Liquidity Ratio is a financial metric that measures the debtor’s ability to pay off present debt obligations without raising external capital.

Current Ratio is a type of liquidity ratio that measures the financial strength of a company.

The formula for Absolute Liquidity Ratio is :

Absolute Liquidity Ratio = Absolute Liquid assets ÷ Total Current Liabilities

 Liquidity ratio is used to compare the financial performance of insurance companies and also used to determine how profitable a company is from year to year.

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