What are Credit Analysis Ratios?
Credit analysis ratios 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) Leverage; (3) Coverage; (4) Liquidity. To learn more, check out CFI’s Credit Analyst Certification program.
As the name suggests, profitability ratios 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 prices will appreciate. It also helps lenders determine the growth of corporations and their ability to pay back loans.
Profitability ratios are split into margin ratios and return ratios.
Margin ratios include:
Return Ratios include
Higher margin and return ratios is 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. It helps credit analysts decide the ability of a business to repay its debts.
Common leverage ratios include:
For leverage ratios, a lower leverage ratio indicates less leverage. For example, if the debt 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.
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 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.
Coverage ratios include:
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 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 debt. Higher liquidy ratios suggest a company is more liquid and can pay off outstanding debts.
Liquidity ratios include:
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 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.
Thank you for reading CFI’s article on credit analysis ratios. CFI is the official global provider of the Certified Banking & Credit Analyst (CBCA)™ 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: