Using ratios to assess fiscal imbalances
As we’ve seen so far, by looking at a financial statement we can grasp a wealth of information about the financial condition of an organisation.
For example, the presence of a net income (ie, a positive ‘bottom line’) is a positive indication that the organisation, on the whole, has generated wealth in an accounting period rather than consuming or wasting it. But if we want to have a deeper understanding of the financial condition, we need to do some more analysis.
A well-established way to analyse the information that we get from financial statements is to calculate some financial ratios. Financial ratios are widely used in the business and banking sectors for appraising how well firms perform, and can have important consequences. For example, a bank’s decision to lend money to a business client depends, among other factors, on the presence of solid financial conditions and prospects for the client’s business.
One such financial ratio is called the Net Working Capital ratio. This simple ratio equals current assets divided by current liabilities. In the 2013/14 financial statement for Camden Council, for example, current assets equal about £278 million and current liabilities equal about £225 million. Net Working Capital ratio, then, equals 278 / 225, that is, about 1.24.
So, what does this ratio actually mean? Remember, current assets are those assets that are expected to be converted into cash in the short term, up to one year in the future; and current liabilities are those liabilities that are expected to be paid in the short term, that is again in one year in the future. The ratio between current assets and current liabilities, therefore, tells us whether the inflow of cash that an organisation expects within a year is greater or smaller than the outflow of cash in the same period. If the ratio is greater than one, then the organisation can safely assume that expected cash inflows one year in the future will be greater than expected cash outflows in the same period: in other words, the organisation will be able to fulfil short term payment of debts and obligations. That’s an important bit of information if you are concerned with the prudent financial management of an organisation.
However, a Net Working Capital ratio greater than one does not guarantee that the organisation will not incur financial issues in the short term. Net Working Capital ratio provides information on the basis of the values indicated in the financial statement. The financial condition of the organisation, however, may worsen after the date when the financial statement is produced. Net Working Capital ratio, in other words, provides an empirical basis for a partial appraisal only of the expected financial condition in the short term. If the ratio is greater than (or equalling) one, this provides reassuring signals that the financial condition at the time when the financial statement was produced is well balanced. A ratio of less than one, instead, emits warning signals that the financial condition is out of balance. The expected cash inflow in the short term is inferior to the expected cash outflow in the same period: the organisation may not have enough money to fulfil their debt and payment obligations in the short term.
Another financial ratio that is quite important in the appraisal of public finances is the debt-to-GDP ratio, where the total debt of a country government is divided by the gross domestic product of the country (ie, how much wealth the country generates through production and trade). What does this ratio mean? The generation of wealth in a country provides a source of income for public finance, in the form of taxation and other income sources. If the debt-to-GDP ratio is relatively high, then the government may have trouble raising income from the economy to pay back their debt and interest on the debt. In such a scenario, the government may need to take measures such as increasing taxes or selling assets (eg, privatisation of public enterprises) to collect the money needed to fulfil payment of debt and obligations. This is one main reason why the debt-to-GDP ratio occasionally attracts the attention of the media: excessive levels of debt-to-GDP ratio call into question the capacity of the government to sustain the level of debt if this is too large with respect to the country’s economy.
How large a level of debt is ‘too large’? This question has no easy answer. Governments can sustain (ie, repay debt and interest) relatively high debt-to-GDP ratios for a relatively long time, especially if debt is issued in the country’s own currency and therefore not exposed to the risk of fluctuating currency exchange rates. However raising income by subjecting residents to excessive taxation or cutting public programmes isn’t always popular or feasible. Think of countries like Japan, where debt-to-GDP ratios are relatively high (central government debt equalled 196% of GDP in 2012), Greece (with a ratio of 163%) and Italy (with a ratio of 127%) (Source: The World Bank).