Credit analysis ratios 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) Leverage; (3) Coverage; (4) Liquidity.
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 help project whether stock prices are likely to appreciate. They also help lenders determine the growth rate of corporations and their ability to pay back loans.
Profitability ratios are split into margin ratios and return ratios.
Gross profit margin:
Gross profit margin is a metric analysts use to assess a company’s financial health by calculating the amount of money left over from product sales after subtracting the cost of goods sold (COGS). Sometimes referred to as the gross margin ratio, gross profit margin is frequently expressed as a percentage of sales.
Gross Profit Margin = (Net Sales – COGS)/ Net Sales
The EBITDA margin is a measure of a company’s operating profit as a percentage of its revenue. The acronym EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Knowing the EBITDA margin allows for a comparison of one company’s real performance to others in its industry.
EBITDA margin = (earnings before interest and tax + Depreciation + amortization) / Total revenue
Operating profit margin:
The operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating income by its net sales. Higher ratios are generally better, illustrating the company is efficient in its operations and is good at turning sales into profits.
Operating Margin= Operating Earnings/ Revenue
Return Ratios include
Return on assets:
The return on assets (ROA) shows the percentage of how profitable a company’s assets are in generating revenue.
ROA = Net Income / Average Total Assets
A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it.
Return on equity:
Return on Equity = Net Income / Average Shareholders’ Equity
Leverage ratios 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 ratio:
Debt to assets ratio = Total Debt / Total Assets
Total Debt = Short Term Debt + Long Term Debt
Total Assets = The sum of the value of all the company’s assets found on a company’s balance sheet
Asset to equity ratio:
The asset to equity ratio reveals the proportion of an entity’s assets that has been funded by shareholders. The inverse of this ratio shows the proportion of assets that has been funded with debt.
Debt to equity ratio:
Debt to Equity Ratio = Total Debt / Shareholders’ Equity
Debt to Equity Ratio = (short term debt + long term debt + fixed payment obligations) / Shareholders’ Equity
Coverage Credit Analysis Ratios
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:
Interest coverage ratio:
The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine how well a company can pay the interest on its outstanding debts. The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called the “times interest earned” ratio.
Interest Coverage Ratio = EBIT / Interest Expense
EBIT = Earnings before interest and taxes
Debt-service coverage ratio:
The debt service coverage ratio (DSCR), also known as “Debt coverage ratio” (DCR), is the ratio of operating income available to debt servicing for interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity’s (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition. Breaching a DSCR covenant can, in some circumstances, be an act of default.
DSCR = Net Operating Income / Total Debt Service
Net Operating Income = Revenue−COE
COE = Certain operating expenses
Total Debt Service = Current debt obligations
Cash coverage ratio:
The cash coverage ratio is useful for determining the amount of cash available to pay for a borrower’s interest expense, and is expressed as a ratio of the cash available to the amount of interest to be paid. To show a sufficient ability to pay, the ratio should be substantially greater than 1:1. The ratio is commonly used by lenders to see if existing borrowers are in financial difficulty, and to determine whether they should loan money to new loan applicants.
Cash Coverage Ratio = (Earnings Before Interest and Taxes + Non-Cash Expenses) ÷ Interest Expense
Asset coverage ratio:
The asset coverage ratio is a financial metric that measures how well a company can repay its debts by selling or liquidating its assets. The asset coverage ratio is important because it helps lenders, investors, and analysts measure the financial solvency of a company. Banks and creditors often look for a minimum asset coverage ratio before lending money.
Though expressed as a ratio, the asset coverage ratio really requires a set of formulation steps, which are as follows:
- Extract from the general ledger the ending balances of all assets.
- Subtract from the total of these assets the amounts recorded on the books for any intangible assets. This deduction is made on the assumption that intangible assets cannot be converted into cash; if this is not the case, retain those intangibles that have a conversion value.
- Extract from the general ledger all current liabilities, not including those liabilities associated with short-term debt.
- Subtract the net liabilities figure in step 3 from the net asset figure derived in step 2. The result should be the amount of assets available for use to pay down debts.
- Divide the net amount derived in step 4 by the ending book balance of all debt outstanding. This includes the amount of any capital leases outstanding.
Liquidity 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 debt. Higher liquidity ratios suggest a company is more liquid and can, therefore, more easily pay off outstanding debts.
The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations. It compares a firm’s current assets to its current liabilities, and is expressed as follows:
Current ratio = Current Assets / Current Liabilities
In finance, the quick ratio, also known as the acid-test ratio is a type of liquidity ratio, which measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. It is defined as the ratio between quickly available or liquid assets and current liabilities. Quick assets are current assets that can presumably be quickly converted to cash at close to their book values.
A normal liquid ratio is considered to be 1:1. A company with a quick ratio of less than 1 cannot currently fully pay back its current liabilities.
QR= CE+MS+AR / CL
QR= CA−I−PE / CL
QR = Quick ratio
CE = Cash & equivalents
MS = Marketable securities
AR = Accounts receivable
CA = Current Assets
I = Inventory
PE = Prepaid expenses
The cash ratio is a measurement of a company’s liquidity, specifically the ratio of a company’s total cash and cash equivalents to its current liabilities. The metric calculates a company’s ability to repay its short-term debt with cash or near-cash resources, such as easily marketable securities. This information is useful to creditors when they decide how much money, if any, they would be willing to loan a company.
Cash ratio = Cash + Cash equivalents / Total current Liabilities
Working capital is the difference between current assets and current liabilities. “Current” again refers to the fact that these items fluctuate in the short term, increasing or decreasing along with operating activities. Generally, these are assets that can be converted into cash within the next 12 months or operating cycle, such as inventory and accounts receivable. Current assets include cash, short-term investments, accounts receivable and inventories.
Working capital ratio = Current assets ÷ Current liabilities