Financial autonomy is the ability of a company or person not to depend on anyone's money to satisfy their purposes. Economic ratios serve us as a great accounting tool to analyze economic states that could be “complex” from the outset. So with a single glance we can see how convenient or favorable is what is being calculated. For this case and article, we are going to explain everything about the financial autonomy ratio.
After reading the article, you will have a complete notion about what the financial autonomy ratio is, how to calculate it and the implications it has for a company. Thanks to this ratio, the decisions that can be made can be more accurate the higher the ratio. Conversely, fewer decisions are considered to be able to be made if the degree of financial autonomy is lower. It also serves as a tool for depending on which companies to calculate how well optimized their own resources are against debt. To fully understand it, be sure to keep reading until the end.
What is the financial autonomy ratio?
The financial autonomy ratio tries to define the dependence that a company has on its creditors, that is, to whom you owe money, the debt. This calculation involves determining the equity that a company has in relation to its debt. In consecuense, the ratio gives us a relationship with their ability to borrow. The higher this ratio, the greater the company's ability to survive in the future, especially taking into account that uncertainty scenarios may arise at some point. A good example would be the current environment that we are going through where the pandemic puts these ratios to the test. Companies with a good autonomy ratio are more likely to be less affected than those whose ratio was not very favorable before the problems that may occur.
Some people use the terms "Equity" to say "Equity", it does not matter. The important thing is that whether we use one or the other words we come to refer to the same thing. In this case, to know the equity, you have to subtract the total liabilities (debt) from the total assets.
Formula to calculate the financial autonomy ratio
As we have commented previously, it is a relationship between equity and debt. The formula is calculated Dividend Equity from total Liabilities (debt) both short and long term. The resulting number is the financial autonomy ratio. In order to understand it better, we are going to present an example with two companies that we imagine are from the same sector. For example, companies that are dedicated to the transport of people.
- In the first case, we find a company whose own funds in total amount to 1.540.000 euros. His total debt amounts to 2.000.000 euros. This means that we divide your own funds between your debt, that is, your liabilities, we obtain 0,77. This would be the ratio of financial autonomy.
- For the second case, we have a company that is smaller in size and has equity of 930.000 euros. Then we have that his total debt amounts to 240.000 euros. After dividing the equity by its debt, we obtain that it has a financial autonomy ratio of 3,87.
For this case and example, I have tried to put a somewhat "famous" case, the second example. On the one hand, we would see how the ratio of the second company is much higher, of 3. It is more stable financially, of that there is no doubt. However, it could surely grow much more, but all that potential would only exist in a latent way, it would not be taking advantage of it.
How to interpret the ratio?
In general, it is said that a company has good financial autonomy when more than half of its resources come from its own funds. But to get an idea, the minimum number of this ratio that a company is expected to have must be 0 or higher. A ratio between 0 and 7 "usually" is the most usual and also the most optimal value.
On the one hand, the company would have liquidity and resources to face difficult times. These moments may not be very difficult, but lowering your guard and being overconfident does not usually lead to good results. On the other hand, we would not be talking about very large indebtedness, which would mean that it has good financial autonomy and in case of need or investments it would not put its survival at risk. For this reason, having or trying to maintain a high ratio is very important, as it represents a sign of strength and stability.
As data, it must be added that there is no universal financial autonomy ratio applicable to all companies. Each sector is different, and it will depend not only on the field in which you are working, but also on the competition and business objectives present at each moment.
How does an increase in debt affect the ratio?
Taking into account the examples of the two companies exposed above, we could see how much more the second company could borrow. Let's see it in perspective. If 1 million euros are requested for investments and/or purchase of assets, the value of the company would increase from its 1.170.000 euros (its assets before discounting the debt to find out the net worth) to 2.170.000 euros.
The debt would increase to 1.240.000 euros (the € 240.000 plus the extra € 1.000.000). His net worth would remain at € 930.000. This means that your financial autonomy ratio would become € 930.000 divided by € 1.240.000 would be 0. Almost the same, as the case of the first company.
Obviously this calculation is simple with round numbers, and in reality the commissions and taxes derived from the liabilities and the acquisition of assets would have to be discounted from the total assets. But when it comes to optimizing economic performance, we can see that now the second company has almost doubled in size. Therefore, your turnover will be higher and your operating cash flow will increase, allowing you to grow more than before. At the same time, it will still have its own resources to face some difficult moment, but the autonomy ratio shows that Borrowing more could become dangerous and would not be recommended.