In matters of business and finance, interest rates affect a wide range of issues. One important aspect of interest rates is the impact they have on budgeting and short-term financial stability. A business's gap ratio is a representation of the effects that interest rates have on its short-term finances.
Two variables determine a business's gap ratio. The first is the sum of all assets that are interest-sensitive. Such assets may be debts that other parties owe the business that are affected by interest rate fluctuations. The second is the sum of all liabilities that are interest-sensitive. Such liabilities may be variable-interest loans on which the business must make payments.
To calculate its gap ratio, a business must divide the total value of its interest-sensitive assets by the total value of its interest-sensitive liabilities. Once it has this quotient, the business may represent it as a decimal or as a percentage.
The purpose of calculating a gap ratio is to gauge how well a business can withstand sudden fluctuations in interest rates. A high number shows financial stability in light of possible interest rate fluctuations, while a low number shows financial instability. For instance, a lender with $3 million worth of interest-sensitive liabilities and $5 million worth of interest-sensitive assets is relatively stable because its gap ratio is approximately 1.67. However, if those numbers were reversed, its gap ratio would be 0.6, showing financial instability.
While the gap ratio can be useful as a sign of financial stability, it is not the only aspect of financial stability. For instance, if only a small portion of a company's total assets are heavily interest-sensitive, even if fluctuations occur, this may not have a heavy effect on financial stability or business solvency.
