What it means
The idea behind the ratio is maturity matching: money that is tied up for years should be funded by money that is committed for years. Buying a factory with a twelve month overdraft creates a structural weakness even if the factory itself is a fine investment.
The measure matters because most funding crises are timing crises. A business can be genuinely valuable and still fail if it must repay short-term debt while its assets are locked into buildings, machinery or long contracts that cannot be turned into cash quickly.
The ratio is calculated by adding equity to non-current liabilities and dividing by non-current assets. A result of 100% means long-term funding exactly covers long-term assets, while a result above that means some long-term money is also supporting day to day working capital, which is generally healthy.
There is no single agreed definition, which is why the term causes confusion. Some analysts use equity divided by total assets as a stability measure, and others use the ratio of equity to fixed assets, so it is always worth checking which version a report is quoting.
Interpretation depends heavily on the industry. Asset-heavy businesses such as hotels or manufacturers are usually expected to sit above 110%, while service firms with few fixed assets can operate comfortably at much lower levels because they have little to fund.
The main caution is that the ratio uses book values and a single date. A property carried at original cost may be worth far more, and a facility repaid the week before the year end will make the picture look better than it typically is.
In practice
Real-world examples.
Example
A bus operator applies to refinance its fleet and the lender calculates a stability ratio of 88%. Because part of the fleet is funded by short-term facilities, the lender offers a longer term loan and prices in the improvement to the structure.
Example
A software consultancy shows a stability ratio of 260% simply because it owns almost no fixed assets. The finance director explains to the board that the number looks impressive but says very little, and points them to cash cover instead.
Example
A food processor buys a $3,000,000 packing line using an overdraft while it arranges permanent finance. Its stability ratio drops from 115% to 82% at the year end, prompting an explanatory note in the accounts for the bank's benefit.
Think of it
“Financial stability shows if you have stable long-term funding for your long-term assets.
Formula
Calculation
The primary form is:
Financial stability ratio = (equity + non-current liabilities) / non-current assets
A commonly used alternative is:
Equity ratio = equity / total assets
A hotel operator reports equity of $4,000,000, non-current liabilities of $2,000,000, non-current assets of $5,000,000 and total assets of $8,000,000.
Long-term funding = $4,000,000 + $2,000,000 = $6,000,000.
Financial stability ratio = $6,000,000 / $5,000,000 = 1.2, or 120%.
The result above 100% means all $5,000,000 of long-term assets are funded by long-term money, with $1,000,000 of long-term funding left over to support working capital.
Using the alternative measure, equity ratio = $4,000,000 / $8,000,000 = 0.50, or 50%, meaning half the asset base belongs to the owners.
If the operator then refinanced $1,500,000 of the long-term loan onto a one year facility, long-term funding would fall to $4,500,000 and the ratio to $4,500,000 / $5,000,000 = 0.90, or 90%, signalling that $500,000 of hotel property is now funded by money due back within twelve months.Case study
Seen in the real world.
The following is an illustrative, fictional example. Penhallow Ceramics, an invented tile manufacturer, expanded by buying a neighbouring unit for $2,400,000, funding it with a mixture of retained profits and a rolling twelve month facility because the rate was cheaper than a term loan.
On paper the fictional company looked profitable, but its financial stability ratio fell from 118% to 79%. When the facility came up for renewal in a tighter credit market, the bank offered renewal at a much higher rate and required a personal guarantee from the directors.
Penhallow refinanced the unit onto a ten year mortgage at a slightly higher headline rate, lifting the stability ratio back above 110%. The finance director's summary in this illustrative story was blunt: the cheaper facility had saved roughly $30,000 a year in interest while creating an annual risk of being unable to refinance a $2,400,000 asset at all.
Watch out
Common mistakes.
- Assuming there is one universal formula, when the term is used for at least three different calculations and comparisons are meaningless unless the same definition is applied to both companies.
- Comparing the ratio across industries, so a consultancy with almost no fixed assets appears far stronger than a manufacturer with a perfectly sound funding structure.
- Reading a single year end figure without checking whether short-term facilities were temporarily repaid just before the reporting date.
Questions
People also ask.
What is a good financial stability ratio?
Above 100% is the general benchmark under the equity plus long-term liabilities definition, with asset-heavy businesses usually expected to sit somewhat higher.
How is it different from the current ratio?
The current ratio looks at short-term assets against short-term liabilities, while the stability ratio looks at whether long-term assets are matched by long-term funding.
Can the ratio be improved quickly?
Yes, mainly by refinancing short-term borrowing onto longer terms, retaining profit instead of paying dividends, or selling assets the business does not need.
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