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 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.  Key ratios can be roughly separated into four groups: (1) Profitability; (2) LeverageLeverageIn finance, leverage is a strategy that companies use to increase assets, cash flows, and returns, though it can also magnify losses. There are two main types of leverage: financial and operating. To increase financial leverage, a firm may borrow capital through issuing fixed-income securities or by borrowing money directly from a lender. Operating leverage can; (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 to meet obligations; (4) LiquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount.. 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 to produce profit 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 help project 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 are likely to appreciate. They also help lenders determine the growth rate 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 a company is generating before taxes, interest, depreciation, and amortization. This guide has examples and a downloadable template
• Operating profit marginOperating Profit MarginOperating Profit Margin is a profitability or performance ratio that reflects 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 expressing as a percentage.

Return Ratios include

• Return on assetsReturn on Assets & ROA FormulaROA Formula. Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit (net income) it's generating to the capital it's invested in assets.
• 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 are 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. Excel template 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.

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. This is because a company that is heavily leveraged faces a higher chance of defaulting on its loans.
• Asset to equity 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 to serve a financial need that otherwise cannot be met outright. Many organizations use debt to procure goods and services that they can’t manage to pay for with cash. 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.

Example

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 ratiosCoverage RatioA Coverage Ratio is used to measure a company’s ability to pay its financial obligations. A higher ratio indicates a greater ability to meet obligations measure the coverage that incomeIncomeIncome refers to the money that is earned by an individual for providing a service or as an exchange for providing a product. The income earned by an individual is used to fund their day-to-day expenditures, as well as fund investments. Some of the most common types of income include salaries, revenue from self-employment, commissions, and bonuses., 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.
• Debt-service coverage ratioDebt Service Coverage RatioThe Debt 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.
• Cash coverage ratio
• Asset coverage ratio

Example

A bank is deciding whether to lend money to Company A which has a debt-service coverage 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 its total outstanding debt 10 times. This is more than Company B, which can only cover its debt 5 times.

Liquidity Ratios

LiquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. 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 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, therefore, more easily 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 a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company
• Quick ratioQuick RatioThe Quick Ratio, also known as the Acid-test, measures the ability of a business to pay its short-term liabilities with assets readily convertible into cash
• 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 obligations with its cash and cash equivalents. Compared to other liquidity ratios such as the current ratio and quick ratio, the cash ratio is a stricter, more conservative measure
• Working capitalWorking Capital FormulaThe working capital formula is current assets minus current liabilities. It's a measure of a company’s short-term liquidity;what's left on the balance sheet

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 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.

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 CFI resources:

• Credit analysisCredit AnalysisCredit analysis is the process of determining the ability of a company or person to repay their debt obligations. In other words, it is a process that determines a potential borrower's credit risk or default risk. It incorporates both qualitative and quantitative factors.
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• 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. Lenders use the credit score to assess a prospective borrower’s qualification for a loan and the specific terms of the loan.