Financial Self-Sufficiency is a ratio that is used in order to evaluate if the company is able to generate enough revenue to cover its costs while ensuring that the equity value is sustained, after incorporating inflation, and another cost of capital.
This particular ratio is considered to be a very useful metric in terms of assessing long-term measurement.
In this regard, it is also important to highlight the fact that this specific metric is used by investors, as well as other financial stakeholders, in order to calculate the overall financial standing of the company in terms of its ability to meet its expenses and ensure that they are able to sustain themselves in the longer run.
Financial Self-Sufficiency is calculated using the following formula:
Financial Self-Sufficiency = Operating Income / (Operating Expenses + Financial Cost + Loan Loss Provision + Cost of Capital (imputed))
In the formula above, it can be seen that operating income includes interest, fees, and other relevant commission income that the company has earned over the course of time.
In the same manner, operating expenses mainly include administrative expenses, and the costs that are incurred to make sure that company is able to sustain itself in a positive manner.
In the same manner, it can also be seen that financial cost includes interest that are paid by the company against the financial instruments that they have drawn on, as well as the fee expenses that are incurred on financing.
As far as the imputed cost of capital is concerned, it can further be seen that it is the figure that can be calculated using metrics like inflation, and the market rate of equity in the discussion.
Example and How to Calculate?
The calculation of financial self-sufficiency can be calculated using the following example:
Elgar Co. has the following finances from the year ended 31st December 2020.
|INCOME STATEMENT||2019 ($)|
|Loan Loss Provision||40,000|
|Net Profit Before Tax||110,000|
|Tax on Profit||10,000|
|Net Profit After Tax||100,000|
Furthermore, the imputed cost of capital calculated was 40,000 based on the inflation rate of 5%.
Depending on the following information mentioned above, it can be seen that following:
Operating Income: Financial Income = 400,000
Operating Expenses = 50,000
Financial Costs = 200,000
Loan Loss Provision = 40,000
Cost of Capital (Impute) = 40,000
Financial Self-Sufficiency = Operating Income [400,000] / (Operating Expenses [50,000] + Financial Cost [200,000] + Loan Loss Provision [40,000] + Cost of Capital (imputed) [40,000])
Financial Self-Sufficiency = 400000 / 330000 = 121.2%
The Financial Self-Sufficiency Ratio mentioned above is proof of the fact that the company is doing well enough to earn its self-sufficient operating revenues in order to meet its expenses. Therefore, this is a positive sign and shows that the company would be fine in the short run.
Financial self-sufficiency is something that is really integral for the very survival of the business. As a matter of fact, it can be seen that financial self-sufficiency results in businesses and companies being able to meet their expenses, and cover all the liquidity-related expenses.
In the same manner, it having a clear idea about financial self-sufficiency somewhat ensures that businesses can keep their investors and their investment on board.
In retrospect, financial self-sufficiency can also help businesses save considerable money by avoiding costly finance charges, which would otherwise be substantial because of the existing high level of risk for the company.
Therefore, this particular metric can act as a signaling effect, which goes in favor of the business.
Regardless of the fact that financial self-sufficiency is considered a very useful tool for gauging the operational efficiency of the firm, yet there is no doubt to the fact that it has certain implications that also need to be accounted for when using this matrix.
In certain cases, for example, a higher self-sufficiency ratio is also indicative of the fact that the organization can further expand its operations and resources in order to get a better return.
In the same manner, it can also be seen that as far as financial self-sufficiency is concerned, there might be a tradeoff between growth, and self-sufficiency.
A business with limited growth and sustained operations might be self-sufficient in terms of operations, but it might not always hold a promising future for the people. Hence, this opportunity cost needs to be accounted for, so that companies can decide what is better for them, strategically.