Last month we explained why the Balance Sheet and liquidity ratios are important to a business owner and we explained the Acid Test and Working Capital liquidity ratios. This month we will discuss the Current Ratio, the Receivables to Payables Ratio and Trust Accounts.
We have all heard the term “In Trust” before. In eighteen states being “in trust” is a part of the law. Californians, as an example, know that being ‘out of Trust’ can be a criminal offense, not just a civil violation. The definition of being “In Trust” means that you have enough cash and receivables to meet your obligations to your carriers. The definition of being “Out of Trust” means that don’t have enough cash and receivables to pay the premiums due to your carriers from your agency bill accounts. The condition of being out of trust occurs when agents have more operating expenses than they generate commissions to pay those expenses and find themselves using collected premiums not yet due the carriers to pay their other costs.
Historically, agencies have used a large pool of agency bill premiums to earn interest from the time they were collected until they were due. This doesn’t sound impressive until we realize that only twenty years ago 75% of agency premiums were agency bill and agents had between 70 and 90 days or more before those monies were due to the carriers. Imagine an agency that generated $1 Million in commissions had as much as $5,000,000 of premiums agency billed each year and, if collected judiciously, this could generate as much as $50,000 of interest income to the agencies in interest bearing accounts until the collected premiums were due the carriers. Those days are long gone. But we still find many agencies that choose to agency bill their major commercial accounts. While the carrier terms have been shortened substantially and this is no longer advantageous to agencies, it still requires billing, collections, interest bearing accounts AND TRUST ACCOUNT ISSUES.
We strongly recommend as good business practice the separation of premium due to the companies from commissions that are kept every month in a separate Trust bank account by the agencies when paying Net Premium Due to the company statements. The commissions are used for paying the agency’s normal operating expenses. The Premiums, maintained in a Trust Account should NEVER be touched except to be drawn to the carriers when due.
The Trust Account liquidity measurement in your balance sheet is Cash (including savings accounts and checking accounts) + Accounts Receivables (which will be addressed below). This calculation should be a positive number every month. The Trust Ratio is that amount divided by insurance company payables and is required to be 100% or better.
Obviously another refined Liquidity Ratio is the agency’s Receivables to Payables Ratio. Assuming that an agency is collecting its premiums regularly, some premiums due the carriers have already been turned into cash. With carrier terms now averaging only 50 days, if you have receivables over 60 days on your Balance Sheet, those monies have often already been advanced to the companies or the accounts are awaiting final disposition (collection) and cancellation. Since you are expected to collect monies within 30 days of billing and most agents are billing renewals as much as 30 days in advance of renewal, the Receivables: Payables Ratio is not expected to be 100%. An adequate measure of Receivables: Payables is 75% or less. This means that you have receivables total less than 75% of your Payables obligation each month, assuming the rest is available already in cash. If you have higher Receivables to Payables Ratios, you should carefully examine your Receivables over 60 days for (a) errors – collected monies not credited against receivables. Sometimes monies inadvertently are credited “on account” for a customer as opposed to against an existing receivable – this is easier but a lazy way of applying money that will “bite you on the backside” eventually, (b) producers or owners who are letting their clients delay payments, or(c) uncollectible bad debts that remain on your books for months or years after the client has become delinquent.
The agency’s Current Ratio is easily measured. It is the Total Current Assets divided by the Total Current Liabilities. The Current Ratio defines an agency’s short term (one year) health. It includes all forms of assets that are liquid enough to be available during the next twelve months including the amounts due to the agency in the next twelve months from any outstanding long term loans. Cash value of life insurance, savings accounts, CDs and liquid investments are included in Current Assets because, if needed, they could all be liquidated to meet the agency’s obligations. Similarly Current Liabilities are those amounts for which the agency is liable in the next twelve months (including borrowed amounts due in the twelve month period). Current Ratio should be 100% or better for an agency to be considered “healthy.”
Next month we will wrap up our analysis of Liquidity Ratios by analyzing the agency’s Tangible Net Worth (TNW), its TNW: Revenue Ratio, its Profits: TNW Ratio, the Debt: Equity Ratio and its Debts: Assets Ratio. While the liquidity ratios discussed last month and this month are critical to the continued operation of the agency, these ratios are indicators of long term health or disease within the agency business.
We have created our own Balance Sheet program (written in Excel) that easily converts your balance sheet to liquidity ratios. The Balance Sheet Program can be purchased on line at www.agencyconsulting.com or you can get a one month trial version for free by calling 800-779-2430. The cost of the program is $150 and comes with lifetime updates as we encounter or update the liquidity ratios in the future.
As always, we are available to analyze, discuss and solve any liquidity problems for any independent agencies noting something amiss in these critical areas. Simply call us 800-779-2430 or e-mail firstname.lastname@example.org to speak to a specialist who can help.