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Strength
Size alone is not the only measure of financial well being. Strength can be even more important. A company's financial strength can be determined from balance sheet entries for stockholder's equity and liability.
One useful way to measure financial strength is to determine the relationship between the portion of the company's total assets invested by the owners and the portion contributed by outside creditors.
This is expressed as a ratio:
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Stockholder Equity
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Total Liabilities |
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In most financially robust companies this ratio should be at least equal to 2:1 (or 2:2), meaning that the owners' investment is two-times that of the creditors — or that two thirds of the property the business owns can be attributed to the owners.
Also look at the relationship between stockholder equity and total assets: |
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Stockholder Equity
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Total Assets |
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This shows the proportion of total property owned by the owners. Strength is considered adequate if this ratio is roughly 2:3. In general, the stronger the company, the less the company owes to creditors and the more the owners have invested in their business.
The strength of a business can also reveal the need for additional life insurance — sometimes in unexpected ways. For instance, if the ratio of Stockholder Equity to Total Liabilities indicates a weakness, the clients may be faced with disproportionately large claims by creditors relative to the owners' investments. If this is the case, key person life insurance might again be needed — this time in amounts sufficient to restore the company's financial structure should one of the key management people die. In fact, unless the weakness indicated in the balance sheet is temporary (which it seldom is), the use of permanent life insurance may be appropriate.
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