Credit analysis ratios are tools that assist the credit analysis process. These ratios help analysts and investors determine whether individuals or corporations are capable of fulfilling financial obligations. Credit analysis involves both qualitative and quantitative aspects. Ratios cover the quantitative part of the analysis.
As the name suggests, profitability ratios measure the ability of the company to generate profit relative to revenue, balance sheet assets, and shareholders’ equity. It is important to investors, as they can use it to help project whether stock prices are likely to appreciate. They also help lenders determine the growth rate of corporations and their ability to pay back loans.
Profitability ratios are split into margin ratios and return ratios.
Higher margin and return ratios are an indication that a company has a greater ability to pay back debts.
Leverage ratios compare the level of debt against other accounts on a balance sheet, income statement, or cash flow statement. They help credit analysts gauge the ability of a business to repay its debts.
For leverage ratios, a lower leverage ratio indicates less leverage. For example, if the debt to asset ratio is 0.1, it means that debt funds 10% of the assets and equity funds the remaining 90%. A lower leverage ratio means less asset or capital funded by debt. Banks or creditors like this, as it indicates less existing risk.
Imagine if you are lending someone $100. Would you prefer to lend to a person that already owes someone else $1000 or someone who owes $100, given both of them make the same amount of money? It is likely you would choose the person that only owes $100, as they have less existing debt and more disposable income to pay you back.
Coverage Credit Analysis Ratios
Coverage ratios measure the coverage that income, cash, or assets provide for debt or interest expenses. The higher the coverage ratio, the greater the ability of a company to meet its financial obligations.
A bank is deciding whether to lend money to Company A, which has a debt-service coverage ratio of 10, or Company B, with a debt service ratio of 5. Company A is a better choice as the ratio suggests this company’s operating income can cover its total outstanding debt 10 times. It is more than Company B, which can only cover its debt 5 times.
Liquidity ratios indicate the ability of companies to convert assets into cash. In terms of credit analysis, the ratios show a borrower’s ability to pay off current debt. Higher liquidy ratios suggest a company is more liquid and can, therefore, more easily pay off outstanding debts.
The quick ratio is the current assets of a company, less inventory and prepaid expenses, divided by current liabilities. A person is deciding whether to invest in two companies that are very similar except that company A has a quick ratio of 10 and the other has a ratio of 5. Company A is a better choice, as a ratio of 10 suggests the company has enough liquid assets to cover upcoming liabilities 10 times over.
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