Credit Analysis Ratios

What are Credit Analysis Ratios?

Credit analysis ratiosFinancial RatiosFinancial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement are used to perform quantitative analysis and assess a company's liquidity, leverage, growth are tools that assist the credit analysis process. These ratios help 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.  Key ratios can be roughly separated into four groups: (1) Profitability; (2) LeverageLeverageLeverage is a strategy that companies use to magnify returns, though it may also magnify losses. To increase Financial Leverage, a firm may borrow capital through issuing fixed-income securities (preferred equity and debt). Operating Leverage can be attained through fixed operating expenses.; (3) CoverageCoverage RatioA Coverage Ratio is used to measure a company’s ability to pay its financial obligations. A higher ratio indicates a greater ability of the company to meet its financial obligations while a lower ratio indicates a lesser ability. Learn Interest Coverage, Debt Service, Cash Coverage, and Asset Coverage ratios, examples; (4) LiquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without impacting its price. In accounting it means how easily a company can. To learn more, check out CFI’s Credit Analyst Certification programCBCA™ CertificationThe Certified Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more. .

Profitability Ratios

As the name suggests, profitability ratiosProfitability RatiosProfitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. They show how well a company utilizes its assets measure the ability of the company to generate profit relative to revenue, balance sheet assets, and shareholders’ equity. This is important to investors as they can use it to determine whether stock pricesStock PriceThe term stock price refers to the current price that a share of stock is trading for on the market. Every publicly traded company, when its shares are will appreciate. It also helps lenders determine the growth of corporations and their ability to pay back loansLoanA loan is a sum of money that one or more individuals or companies borrow from banks or other financial institutions so as to financially manage planned or unplanned events. In doing so, the borrower incurs a debt, which he has to pay back with interest and within a given period of time..

Profitability ratios are split into margin ratios and return ratios.

Margin ratios include:

• Gross profitGross ProfitGross profit is the direct profit left over after deducting the cost of goods sold, or "cost of sales", from sales revenue. It's used to calculate the gross profit margin and is the initial profit figure listed on a company's income statement. Gross profit is calculated before operating profit or net profit. margin
• EBITDA marginEBITDA MarginEBITDA margin = EBITDA / Revenue. It is a profitability ratio that measures earnings the company is generating before taxes, interest, depreciation, and amortization. The margin does not include capital expenditures or changes in working capital. This guide has examples and a downloadable template
• Operating profit marginOperating Profit MarginOperating Profit Margin is a profitability, or performance, ratio used to calculate the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue, and expressed as a percentage.

Return Ratios include

• Return on assetsReturn on Assets & ROA FormulaReturn on assets (ROA), a form of return on investment, measures the profitability of a business in relation to its total assets. The ROA formula is used to indicate how well a company is performing by comparing the profit it's generating to the capital it's invested in assets.  The higher the return, the more
• Risk-adjusted returnRisk-Adjusted Return RatiosThere are a number of risk-adjusted return ratios that help investors assess existing or potential investments. These ratios can be more helpful than simple investment return metrics that do not take the level of investment risk into account.
• Return on equityReturn on Equity (ROE)Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity.

Higher margin and return ratios is an indication that a company has a greater ability to pay back debts.

Leverage Ratios

Leverage ratiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement.  Leverage ratios include debt/equity, debt/capital, debt/assets, debt/EBITDA, and interest coverage. This guide has exmaples and Excel template compare the level of debt against other accounts on a balance sheet, income statement, or cash flow statement. It helps credit analysts decide the ability of a business to repay its debts.

Common leverage ratios include:

• Debt to assets ratioDebt to Assets RatioThe Debt to Assets Ratio is a leverage ratio that helps quantify the degree to which a company's operations are funded by debt. In many cases, a high leverage ratio is also indicative of a higher degree of financial risk.
• Asset to equtiy ratio
• Debt to equity ratioDebt to Equity RatioThe Debt to Equity Ratio is a leverage ratio that calculates the value of total debt and financial liabilities against the total shareholder’s equity.
• Debt to capital ratio

For leverage ratios, a lower leverage ratio indicates less leverage. For example, if the debtDebtDebt is the money borrowed by one party from another entity to serve a need that otherwise cannot be met outright. Many organizations use debt to procure to asset ratio is 0.1, it means 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.

Example

Imagine if you are lending someone $100. Would you prefer to lend to a person that already owes someone else $1000 or $100 given both of them make the same amount of money? It is likely you choose the person that only owes $100 as they have less existing debt and has more disposable income to pay you back.

Coverage Ratios

Coverage ratiosCoverage RatioA Coverage Ratio is used to measure a company’s ability to pay its financial obligations. A higher ratio indicates a greater ability of the company to meet its financial obligations while a lower ratio indicates a lesser ability. Learn Interest Coverage, Debt Service, Cash Coverage, and Asset Coverage ratios, examples measure the coverage that incomeIncomeIncome refers to the amount of money that is earned by an individual for providing a service or as an exchange for providing a product. The income earned by, cash, or assets provide for debt or interest expensesInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also be calculated through the debt schedule. The schedule should outline all the major pieces of debt a company has on its balance sheet, and calculate interest by multiplying the. The higher the coverage ratio, the greater the ability of a company to meet its financial obligations.

Coverage ratios include:

• Interest coverage ratioInterest Coverage RatioInterest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt. The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called “times
• Debt-service coverage ratioDebt Service Coverage RatioDebt Service Coverage Ratio (DSCR) measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt. DSCR is often used when a company has any borrowings on its balance sheet such as bonds, loans and line
• Cash coverage ratio
• Asset coverage ratio

Example

A bank is deciding whether to lend money to Company A which has a debt-service ratio of 10 or Company B that has a debt service ratio of 5. Company A is a better choice as the ratio suggests this company’s operating income can cover the total debt 10 times. This is more than Company B that can only cover it 5 times.

Liquidity Ratios

LiquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without impacting its price. In accounting it means how easily a company can ratios determine 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 debtCurrent DebtOn a balance sheet, current debt is debts due to be paid within one year (12 months) or less. It is listed as a current liability and part of net working capital. Not all companies have a current debt line item, but those that do use it explicitly for loans incurred with a maturity of less than a year.. Higher liquidy ratios suggest a company is more liquid and can pay off outstanding debts.

Liquidity ratios include:

• Current ratioCurrent Ratio FormulaThe Current Ratio formula is = Current Assets / Current Liabilities. The current ratio, also known as the working capital ratio, measures the capability of
• Quick ratioQuick RatioThe Quick Ratio, also known as the Acid-test or liquidity ratio, measures the ability of a business to pay its short-term liabilities by having assets that are readily convertible into cash. These assets are, namely, cash, marketable securities and accounts receivable. These assets are known as "quick" assets since
• Cash ratioCash RatioThe cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric that indicates a company’s capacity to pay off short-term debt
• Working capitalWorking Capital FormulaThe working capital formula is current assets minus current liabilities. The working capital formula measures a company’s short-term liquidity and tells us what remains on the balance sheet after short-term liabilities have been paid off. Working capital can be positive or negative and is used for managing cash flow

Example

The quick ratio is the current assets of a company less inventory and prepaid expenses divided by current liabilitiesCurrent LiabilitiesCurrent liabilities are financial obligations of a business entity that are due and payable within a year. A company shows these on the balance sheet. A liability occurs when a company has undergone a transaction that has generated an expectation for a future outflow of cash or other economic resources.. A person is deciding whether to invest in two companies that are very similar except company A has a quick ratio of 10 and the other with 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.

Additional Resources

Thank you for reading CFI’s article on credit analysis ratios. CFI is the official global provider of the Certified Banking & Credit Analyst (CBCA)™CBCA™ CertificationThe Certified Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more. program designed to help you rise through the ranks as a credit analyst.

To keep learning and advancing your career, we recommend the following resources:

• Credit analysisCredit AnalysisCredit analysis is the process of determining the ability of a company or person to repay its debt obligations. In other words, it is a process that
• Ratio AnalysisRatio AnalysisRatio analysis refers to the comparisons between different pieces of financial information in the financial statements of a business. They are mainly used
• Credit analyst job description Credit Analyst Job DescriptionThis Credit Analyst Job Description outlines the key skills, experience, and education for the position. A credit analyst needs to assess the creditworthiness of a borrower and the risk profile of a loan. This is a typical example of a credit analyst job description based on real postings from lenders like HSBC
• Credit ScoreCredit ScoreA credit score is a number representative of an individual's financial and credit standing and ability to obtain financial assistance from lenders.