Financial Analysis for D&O Insurance: 3 Key Metrics

D&O has, more than most types of insurance, always performed risk analysis based primarily on the accounts of a company. For most underwriters, they might never need to look at a company balance sheet in their time – but for us D&O practitioners it’s almost a way of life.

But what are we actually looking at when we get a hold of your clients’ accounts? Is it simply a case of making sure your client made a profit, or are we checking for any large, unspecified chunks of money that have mysteriously disappeared?

Well, in truth it’s a little of the above but also a lot more. It’s important to remember firstly however that underwriters are not forensic accountants. Some of us might enjoy looking over company accounts, but we aren’t asking the insured to account for every penny they spent in the last five years. Remember, most underwriters only get a most a few days to look over a risk before a broker expects terms to be put down, and sometimes it’s just a matter of hours! Instead, what we are looking at is for general warning signs that something is amiss, be that a looming default on debts or management taking financial decision which are unusual in their industry.

In order to do this, we use a number of ratios and analysis tools which help us quickly break down the client’s balance sheet, profit and loss and cashflow into metrics we can compare against industry competitors and also changes over the life of the company. Whilst there are a vast number of these metrics, today we are going to look at three fundamental ones.

1. Current Ratio

Also known as the working capital ratio, the current ratio is a very simple and quick litmus test of a company’s short-term liquidity. By comparing the current assets against current liabilities, we can quickly assess if, on paper, the company looks like it has the ability to meet liabilities as they fall due over the next 12 months (without additional external debt or equity funding).

The calculation for the current ratio is a very simple one:

Current Assets / Current Liabilities = Current Ratio

Underwriters ideally want the answer to be above 1.

Although an excellent starter metric, current ratio is by no means perfect. It is a relatively lenient measure of liquidity from the insured’s perspective as it includes all current assets and assumes these will both be immediately available and that their book value is true value. Take stock for example, if the insured needs cash quickly they may be forced to sell in bulk for pennies on the pound. Debtors is another classic current asset, but if the debtors don’t pay you…

Some underwriters might therefore use either the acid ratio (which excludes stock), or the cash ratio (which is simply cash in bank and hand over current liabilities).

2. Interest Coverage

Interest coverage is designed to help us understand the ability of the company to meet the interest payments due on its debt. After all, interest can really add up to cause the company financial hardship, and especially with rising inflation and the current direction of the economy this is a key concern on underwriter’s minds.

We also want to ensure that a company is not simple servicing it’s debts (lest they become a “zombie company”, which you can read about here), but that they are actively able to pay down their debts to secure the financial future of the company.

You will need to dig into the accounts a little deeper for this one, because interest expense is often hidden in the explanatory notes rather than show separately on the balance or P&L.

The calculation looks like this:

Operating Profit (or EBIT) / Interest Payable.

Ideally, the minimum underwriters want to see is a result of 1.5 or better. A score between 1.4 and 1 suggests the company can meet interest but will struggle to pay down any of the loans principal amount, and anything below 1 suggests there might be an interest time bomb growing in the insured….

Again however, this ratio isn’t perfect. Whilst 1.5 is the minimum amount we often seek ratios in excess of this to ensure stability. It also doesn’t account for the terms of the interest, if that interest rate is flexible for example, it may go up or down and so with it our ratio. Some companies also naturally experience fluctuations in operating patterns which, if not considered in your evaluation, can make it seem worse than it really is. For this reason it is always important to compare against other industry peers.

3. Gearing

Finally, we have the Gearing %. Also known as leverage, gearing indicates how much of the companies activities are funded by debt as opposed to shareholder equity. Because shareholder equity is generally the safer of the two equity strategies, this important metric lets us know if it looks like the company has bitten off more than it can chew with it’s loans.

Gearing ratio is perhaps a bit of a misnomer is that it refers more to a family of calculations rather than one specific one. The most common equation however is the simplest, known also as the debt-to-equity ratio, which looks like this:

Total Debt / Total Equity x 100

Unlike the other two, this equation is designed to return a % result. Gearing requires a significant amount of context to determine what is “good” or “normal” for each client, but a very general rule of thumb is:

• >50% = highly leveraged

• 50 – 25% = normal leverage

• <25% = low leverage

Of course, gearing is very situation dependent. For example early life companies might have significantly higher leverage as they seek equity investment or invest in the business for growth. Other business’ in certain trade, such s regulated or semi-monopolistic industries (utilities etc.) can operate with far higher gearing ratios than other companies, so it is always subjective.

Summary

Hopefully this article helps give a quick insight into the financial analysis undertaken by D&O underwriters and might help a broker or two understand what and why underwriters ask the questions they do when we get your clients accounts. It also highlights why it is important to provide up-to-date financials, as ratios change all the time and especially for insured who may have struggled over 2020/21, producing accounts from a post-lockdown time will help underwriters enormously to contextualise the pandemic results.