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Key Financial Ratios for the Credit Department
by Michael C. Dennis, M.B.A., C.B.F.

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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