Sterling Ratio: What It Is, How to Calculate, and Its Importance

The Sterling ratio is a financial metric that helps investors and analysts evaluate a company's ability to pay its debts. It's calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses.

A Sterling ratio of 3 or higher is generally considered good, as it indicates that a company can easily cover its interest expenses. This is because a higher ratio suggests that a company has a strong balance sheet and can manage its debt effectively.

The Sterling ratio is an important tool for investors and analysts, as it provides insights into a company's financial health and ability to pay its debts. By understanding the Sterling ratio, you can make informed decisions about investing in a company.

The Sterling Ratio is a measure used to evaluate an investment's or strategy's performance relative to its downside risk. It specifically focuses on the return achieved per unit of downside risk.

This ratio is primarily used in hedge funds to measure their risk-adjusted performance. The Sterling Ratio is a unique measure of risk-adjusted performance that might make it a helpful tool for investors.

The Sterling Ratio uses the average drawdown, not standard deviation, to assess risk. This is because drawdowns, not volatility, are what really matter to investors.

A higher Sterling ratio indicates a more favorable balance between risk and reward for an investment or strategy relative to a risk-free option. This implies that the investment offers comparatively advantageous returns in terms of the average annual drawdown.

The Sterling Ratio is designed as an alternative for comparison with other measures that account for risk adjustment. This calculation offers investors insight into their returns relative to risks encountered, particularly when their investments underperform significantly.

The Sterling Ratio calculator is a handy tool for evaluating risk-adjusted returns, but if you want to calculate it yourself, there are a few steps to follow.

To calculate the Sterling Ratio in Excel, you'll need to start with a time-series of security returns to generate drawdowns. This involves calculating the average annual drawdown, excess return, and maximum drawdown.

You can use the MIN and MAX functions in Excel to find the lowest value of the investment and the peak before the largest drop. The average drawdown can be calculated by summing all the individual drawdowns and dividing by the number of drawdown periods.

The Sterling Ratio formula is: periodic portfolio return / (Average Annual maximum Drawdown – 10%). This can be annualized if the returns and drawdowns are for periods over one year by adjusting the formula accordingly.

A Sterling ratio of 1.5 indicates that for every unit of downside risk, the investment generated 1.5 units of excess return. This implies a favorable risk/reward tradeoff, with returns notably higher than the average drop in value the investment experiences annually.

To compute the Sterling ratio, you can divide the compound annualized return over the previous three years by the average yearly maximum drawdown over the same period with a 10% deduction. A higher Sterling ratio indicates superior performance, reflecting a greater return relative to the risk incurred.

Here's a step-by-step guide to calculating the Sterling ratio:

A Sterling ratio of 1.5 indicates a favorable risk/reward tradeoff, with returns notably higher than the average drop in value the investment experiences annually.

The Sterling ratio aims to measure risk-adjusted returns for an investment by considering the return per unit of downside risk. This unique measure of risk-adjusted performance might make the Sterling Ratio a helpful tool for investors seeking to understand the return potential of their investments relative to the risk involved.

A higher Sterling ratio indicates a more favorable balance between risk and reward for an investment or strategy relative to a risk-free option.

To put the Sterling ratio into perspective, consider the following:

A lower Sterling ratio indicates that a portfolio’s performance may not adequately compensate for the risks undertaken, suggesting that the risk-adjusted returns are insufficient given the level of risk incurred.

The Sterling ratio should not be the sole determinant in investment decision-making. Other factors, such as the investment’s objectives, the investor’s risk tolerance, and market conditions, should also be considered.

The sterling ratio is a useful tool for evaluating a company's financial health and making informed investment decisions. In practice, it's often used by investors and analysts to compare a company's profitability with its capital structure.

A high sterling ratio indicates that a company is generating a significant amount of cash from its operations and has a strong ability to pay its debts. For example, a company with a sterling ratio of 3:1 has three times as much cash generated from operations as it has in total debt.

However, a high sterling ratio can also indicate that a company is not investing enough in its business, which can hinder its growth and competitiveness. This is because a high sterling ratio often means that a company is hoarding cash rather than using it to invest in new projects or expand its operations.

On the other hand, a low sterling ratio can indicate that a company is over-leveraged and may struggle to meet its debt obligations. For instance, a company with a sterling ratio of 1:1 has as much debt as it has cash generated from operations, which can be a sign of financial distress.

Ultimately, the sterling ratio is just one tool that investors and analysts can use to evaluate a company's financial health. It's essential to consider other factors, such as the company's industry, market trends, and management team, to get a more complete picture of its financial situation.

The sterling ratio has its fair share of advantages and disadvantages. One of the main advantages is that it's a simple and straightforward way to measure drawdowns.

However, it also has some significant drawbacks. The sterling ratio works on the assumption that drawdowns exhibit symmetry, but human psychology tends to magnify the impact of losses.

This means that the sterling ratio can be overly optimistic about the potential for gains to offset losses. It also overlooks tail risk, such as extreme events and deviations from normal return distributions.

Here are some of the specific disadvantages of the sterling ratio:

You should use the Sterling Ratio to measure risk-adjusted returns, especially when evaluating alternative investments like hedge funds, where understanding the return over average drawdown is more relevant than the return over maximum drawdown or volatility.

The Sterling Ratio is great for comparing different investments and asset classes based on how much return they generate per unit of average annual drawdown.

Investors who are more concerned with the consistency of returns and managing downside risk rather than simply searching for the best returns may like the Sterling Ratio.

It's best to use the Sterling Ratio without any adjustment for the risk-free investment, as the risk-free rate might be rather irrelevant when comparing funds and strategies.

Two investments with the same Sterling Ratio suggest similar risk-adjusted performance, but it doesn't necessarily mean their overall risk profiles are identical.

The Sterling Ratio has its fair share of advantages and disadvantages. One of the main advantages is that it works on the assumption that drawdowns exhibit symmetry, but this doesn't always hold true in reality.

However, the Sterling Ratio has some significant drawbacks. It fails to consider the impact of human psychology on losses, which tends to be magnified. This means that the ratio might not accurately account for the emotional toll of losses.

The Sterling Ratio also overlooks tail risk, including extreme events and deviations from normal return distributions. This can lead to inaccurate predictions and poor investment decisions.

Historical data might not provide precise forecasts for future drawdowns, which can make the Sterling Ratio less reliable. This is because past performance is not always indicative of future results.

Here are some of the main disadvantages of the Sterling Ratio:

The Sterling ratio is often compared to other ratios, such as the Sharpe ratio, to determine its effectiveness in measuring risk-adjusted return.

One key difference between the Sterling ratio and the Sharpe ratio is that the Sharpe ratio uses volatility as the measure of risk, whereas the Sterling ratio uses drawdowns, or downside deviation, as the risk metric.

The Sterling ratio assesses risk by calculating the average yearly drawdown rather than the standard deviation, which is used by the Sharpe ratio.

This difference is important because it highlights the variability factor of the returns, whereas the Sterling ratio emphasizes the average loss from the highest to the lowest position within a single year.

A high Sterling ratio indicates that an investment has a favorable risk/reward tradeoff, with returns notably higher than the average drop in value the investment experiences annually.

Here's a comparison of the two ratios:

While a high Sterling ratio can indicate an investment that has historically offered good returns for the level of risk taken, you must consider the nature of the investment, the investment horizon, the market conditions, and the specific objectives of the investor.

The Sterling Ratio can be a bit tricky, especially when it comes to negative values. Yes, it can indeed be negative, and this happens when the returns on an investment are not only below average but also fail to compensate for the associated risk.

A negative Sterling Ratio is calculated by taking the absolute value of the average annual drawdown and subtracting 10%. This 10% refers to the risk-free rate in 1981, which is much lower today.

This means that combining a negative drawdown with subpar investment performance could indeed yield a negative Sterling ratio. Deane Sterling Jones, who devised this metric, initially incorporated a standard of 10% returns within its denominator to evaluate risk versus reward dynamics.

Underachievement relative to such a benchmark is another scenario where an investment's Sterling ratio might turn negative.

In fact, a Sterling ratio of 1.5 is considered a good sign, indicating that for every unit of downside risk, the investment generated 1.5 units of excess return. This implies a favorable risk/reward tradeoff.

A Sterling ratio higher than 1.0, such as 1.5, indicates that the investment has a risk-adjusted performance that surpasses that of a risk-free investment, according to the original rationale behind including the 10% figure in the denominator of the Sterling ratio formula.

It's essential to consider the nature of the investment, the investment horizon, the market conditions, and the specific objectives of the investor when evaluating the Sterling ratio.