4 Important Credit Analysis Ratios
Credit analysis is associated with the decision to grant credit to a customer. It is also part of a bank’s lending procedures for making a loan and monitoring the borrower’s creditworthiness. (or)
“Simple words from Wikipedia: Credit analysis is the method by which one calculates the creditworthiness of a business or organization. In other words, it is the evaluation of the ability of a company to honor its financial obligations. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan. The term refers to either case, whether the business is large or small.”
Credit analysis ratios across 4 categories:
- Liquidity Ratios,
- Leverage Ratios,
- Coverage Ratios,
- Profitability Ratios.
#1 Liquidity Ratios
Liquidity 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.
Current Ratio = Current Assets ÷ Current Liabilities
Here,Current Assets means Stock, Debtor, Cash and bank, receivables, loan and advances, and other current assets.
Current Liability means Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current liability
Quick Ratio= (Cash & equivalents + marketable securities + accounts receivable) ÷ Current liabilities. (or)
Quick Ratio = [Current Assets – Inventory Prepaid expenses] ÷ Current Liabilities
Quick Assets means Current Assets Inventory Prepaid Expenses
(Quick Ratio also called the acid test ratio. It measures a business’ liquidity)
Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities
Working capital = Current Assets Current Liabilities
# 2 Leverage Ratios
This ratio focus on the long-term solvency of the company with regards to how much capital comes in the form of debt or assessing the ability of the company to meet its financial obligation.
Equity Ratio = Shareholder’s Equity ÷ Capital Employed
Shareholder’s Equity = Share Capital + General Reserves + Surplus + Retained Earnings
Capital Employed = Total Assets Current Liabilities (or) Fixed Assets + Working Capital
Debt Ratio= Total Debt/ Total Capital Employed
(Here, Total Debt means Short Term and Long-Term Borrowings, Debentures and Bonds)
Debt-to-Assets Ratio = Total Debt ÷ Total Assets (Or) Total Outside Liabilities ÷ Total Assets
(Here, Total Assets = Current Assets + Non-current Assets)
Debt-to-Equity Ratio = Total Debt ÷ Total Equity
Debt-to-Capital Ratio = Today Debt ÷ (Total Debt + Total Equity)
Debt-to-EBITDA Ratio = Total Debt ÷ Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
Asset-to-Equity Ratio = Total Assets ÷ Total Equity
#3 Coverage Ratios
Coverage ratios measure a company’s ability to service its debt obligations. While the liquidity ratios above focused on what could happen in a liquidation, coverage ratios provide an indication that a firm can remain a viable operating business
Interest Coverage Ratio = E.B.I.T. (Earnings before interest and tax) ÷ Interest
Debt Service Coverage Ratio = (Earnings available for Debt Services) ÷ (Interest liabilities + Installments)
Preference Dividend Coverage Ratio = E.A.T. (Earnings after tax) ÷ Preference dividend liability
Fixed Charges Coverage Ratio = (E.B.I.T. + Fixed charges before tax) ÷ (Interest + Fixed charges before tax)
Asset Coverage Ratio = ((Total Assets Intangible Assets) (Current Liabilities Short-term Portion of LT Debt)) ÷ Total Debt
Cash Coverage Ratio Formula = (EBIT + Non-Cash Expense) ÷ Interest Expense
#4 Profitability Ratios
The Profitability Ratios measure the overall performance of the company in terms of the total revenue generated from its operations.
(Or)
Profitability ratio is used to evaluate the company’s ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period. This ratio represents the final result of the company.
a.Profit Margin Ratios
Gross Profit Margin Ratio =Gross Profit÷ Net Sales 100
(Gross Profit= Sales + Closing Stock op stock Purchases Direct Expenses)
Operating Profit Margin Ratio =
(Cost of Revenue from Operations + Operating Expenses ÷ Revenue from Operations) 100
Net Profit Margin Ratio = Net Profit ÷ Sales 100
Net Profit = Revenue from Operations Cost of Revenue from Operations Operating Expenses Non-operating Expenses + Non-operating Incomes Tax
b.Rate of Return Ratios
Return on Assets Ratio = Net Income ÷ Average Assets
Return on Equity Ratio = Profit after Tax ÷ Net worth
Net Worth means Equity share capital, and Reserve and Surpl
Return on Capital Employed = Net Operating Profit ÷ Capital Employed 100
(Capital Employed means Equity share capital, Reserve and Surplus, Debentures and long-term Loans)
Capital Employed = Total Assets Current Liability
Return on Investment = (Net Profit before Interest, Tax and Dividend ÷ Capital Employed) 100
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