# A White Paper

Ratio analysis is an excellent method for determining the overall
financial condition of a customer's business. Ratios are also useful
for making comparisons between a customer and other businesses
in an industry. In my opinion, each of the following ratios is
important in helping credit professionals to make informed decisions
about whether to extend credit to customers, how much credit to
extend, and what terms of sale are appropriate.

Readers are encouraged to remember that a financial ratio is a simple mathematical
comparison of two entries from a company's financial statements. There are
literally hundreds if not thousands of ratios that could be calculated using
information from a customer’s Balance Sheet, Income Statement and Cash
Flow Statement. The key is for credit professionals to select ratios that they
believe are indicative of [1] a customer’s ability to pay its debts as
they come due and [2] the customer or applicant’s long term viability.
Credit professionals can use the following financial ratios to chart trends
in a customer’s financial performance, to find trends, and point to potential
problem areas that require additional scrutiny by the credit manager.

**Liquidity
Ratios**

These ratios indicate the ease of turning current assets into
cash. Liquidity refers a company's ability to meet current obligations with
cash or other assets
that can be quickly converted to cash. Liquidity ratios give an indication
of a company's ability to retire debts as they come due. Liquidity ratios
include the Current Ratio, and the Quick Ratio.

*The Current ratio formula is: Current assets divided by current
liabilities.

The current ratio is one of the best-known measures of financial liquidity.
The current ratio is the standard measure of any business' financial health.
It will tell you whether your business is able to meet its current obligations
by measuring if it has enough assets to cover its liabilities.

*The Quick ratio formula is: (Current assets less inventories)
divided by current liabilities. The quick ratio (also sometimes
called the acid test ratio) measures a business' liquidity. However,
many financial planners consider it a tougher measure than the
current ratio because it excludes inventories when counting assets.
It is a more strenuous version of the "current ration indicating
whether current liabilities could be paid without selling inventory.

**Leverage
ratios**

Leverage ratios measure the relative contribution of stockholders
and creditors. Leverage ratios indicate the extent to which
the business is reliant on debt
financing (debts owed to creditors versus owner's equity). Leverage ratios
show the extent that debt is used in a company's capital structure.

*The
Debt to Equity ratio formula is: Total liabilities divided by
total equity.

This ratio indicates how much the company is leveraged (in debt) by comparing
what is owed to what is owned. A high debt to equity ratio could indicate
that the company may be over-leveraged, and should look for ways to reduce
its debt.

*The interest coverage ratio formula is: Earnings before Interest,
Taxes, Depreciation and Amortization divided by Interest Expense.

This ratio indicates what portion of debt interest is covered by a company's
cash flow situation.

**Profitability ratios**

Profitability refers to a company's ability
to generate revenues in excess of the costs incurred in producing
those revenues.

*The Gross profit margin formula is: Gross Profit
divided by Total Sales.

Net sales minus cost of goods sold equals gross profit. The gross
profit margin ratio indicates how efficiently a business is
using its materials
and labor
in the production process. It shows the percentage of net sales remaining
after subtracting the cost of goods sold.

*The Return on sales formula is: Net profit [net income after
tax] divided by Sales.

This ratio compares after tax profit to sales. It can help you determine if
customers are making an adequate return on sales.

*The return on equity ratio formula is: Net income divided by
Shareholders equity

It indicates what return a company is generating on the owners' investment.

*The
return on assets formula is: Net Income divided by Average total assets.

The higher the rate of return on assets, the better from a creditor’s
point of view.

**Efficiency ratios**

Efficiency ratios measure how well the company
and its management uses the assets under their control to generate
sales and profits.

*The Payables turnover ratio formula is: Cost of sales divided
by trade payables

This number reveals how quickly a company under review pays its bills. The
payables turnover ratio reveals how often payables turn over during the year.
A high ratio means there is a relatively short time between purchase of goods
and payment. The importance of this ratio to creditors should be apparent.

*The Inventory turnover ratio formula is: Cost of goods sold divided
by Average inventory.

In general, the higher the turnover ratio
the better the company under review is performing.

*The Return on assets (ROA) ratio formula is: Earnings before
interest and taxes (EBIT) divided by net operating assets.

This efficiency
ratio indicates how effective a company has been in utilizing its
assets. The ROA ratio is a test of capital utilization - how much
profit
(before interest and income tax) a business earned on the total capital employed.

*The Asset turnover formula is: Net sales divided by Average total
assets.

Asset turnover is an indicator of how efficiently a firm utilizes
its assets. If the ratio is high, it implies that the firm is using
its assets efficiently
to generate sales – and ultimately profits.

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