Balance sheet ratios play an important role in business life. Almost every investor, including their own house bank, takes a critical look at the annual financial statements before they are ready to invest. A very well-known balance sheet figure is the golden balance rule, also known as the golden balance rule, which we present in this article.
What is the golden rule of accounting?
“Long-term tied assets are to be financed long-term, short-term assets short-term”
So, the rule requires that the capital of a company that in the fixed assets is invested long-term shall also be available , while the financing of working capital over the short term funds raised can take place. Ultimately, the rule therefore requires matching maturities between assets and liabilities on the balance sheet .
Classification of the golden rule of balances in the key figure system
In business investment and finance theory, a distinction is made between three types of finance rules:
- liquidity rules
- vertical proportionality rules
- horizontal proportionality rules
According to foodanddrinkjournal.com, the first category includes the known degrees of liquidity, which focus on the company’s short-term solvency and are intended to help optimize cash flow . The vertical proportionality rules focus on the liability side of the balance sheet and examine the relationship between equity and debt . Their horizontal counterparts, on the other hand, establish a relationship between assets and liabilities . The most famous representatives include the golden rule of financing and the resulting golden rule of balances. The proportionality rules make specifications for the balance sheet structure. In our calculation examples, we therefore use so-called structural balances, just like professional analysts.
What role does maturity congruence play?
A company can only survive economically and legally if it can meet its financial obligations at all times . This is where the maturity congruence , on which many key figures are based, comes in.
The capital (liabilities) that is used to finance assets (assets) must be available to the company until it is amortized . When it comes to current assets , especially inventories, the realistic assumption is that they will be handled quickly and resold as finished products or as merchandise. Inventories generate short-term cash flows that flow back into the company. The funds that are required for their financing therefore only have to be available for a short time.
In the case of fixed assets , on the other hand, there are other requirements. Land, buildings and machines are required for the production of goods and services and remain with the company over the long term. Their amortization takes place over years, sometimes over decades, through the scheduled depreciation for wear and tear (depreciation). A company must therefore be able to dispose of the funds tied up in fixed assets over a long period of time.
The golden rule of accounting transforms this principle into calculable key figures.
The golden rule of accounting as a key figure
The golden accounting rule can be broken down into two balance sheet ratios, which are referred to as coverage ratio 1 and coverage ratio 2 .
The coverage ratio 1 is the golden rule of balances in the narrower sense and describes the relationship between equity and fixed assets, whereby the quotient should be greater than or equal to 1.
Coverage ratio 1: equity / fixed assets ≥ 1
If the above requirement is met, then a company finances its entire fixed assets with equity and is independent of banks and other lenders in this regard.
Coverage ratio 2 also takes long-term debt into account
Coverage ratio 2: (equity + long-term debt) / fixed assets ≥ 1
If only coverage ratio 2 is met, the company’s equity is not sufficient to finance all of its fixed assets, but it does have sufficient outside capital. Long-term financing is also secured in this case, but the company is dependent on external donors. Coverage ratio 2 is therefore often referred to as the silver financing rule.
Calculation of the golden balance rule using the example
The calculation can best be explained using an example.
The opening balance sheet for the year 02 of the Muster-GmbH, which is identical to the balance sheet of the annual financial statements 01, shows the following structure:
|Claims from L + L
|Liabilities (> 1 year)
|Liquid funds (cash register, bank)
|Liabilities from L + L (≤ 1 year)
Calculation of coverage ratio 1:
Equity / fixed assets = 500 / 1,000 = 0.5 <1
In the example, the coverage ratio 1 is less than 1, so the sample GmbH fails to meet the golden balance sheet rule at the beginning of the 02 financial year. The company can now check whether adjustments are required for the coming fiscal year. For example, due to a larger investment that is to be financed with outside capital, as the balance sheet structure can affect the financing conditions. In this case, for example, converting a shareholder loan into a capital contribution would improve coverage ratio 1. However, the company should first take a look at Coverage Ratio 2 before considering measures.
Calculation of coverage ratio 2:
(Equity + long-term debt) / Fixed assets = (500 + 250 + 450) / 1,000 = 1.2> 1
Taking long-term debt into account, including pension provisions and all liabilities with a remaining term of more than one year, the company achieves target value 1 and even exceeds it slightly. The Muster-GmbH thus fulfills the silver accounting rule. Since hardly any company in Germany complies with the golden rule, it would not incur any disadvantages, at least because of this balance sheet ratio alone.