Credit Analyst Financial Ratios in Business Credit Analysis

As a credit analyst, you're likely no stranger to financial ratios. However, it's essential to understand the specific ratios used in business credit analysis to make informed decisions.

The Current Ratio is a crucial metric, as it measures a company's ability to pay its short-term debts. A Current Ratio of 1 or higher indicates a company can cover its short-term debts with its current assets.

A low Current Ratio, on the other hand, can be a red flag, indicating potential liquidity issues. This ratio is calculated by dividing current assets by current liabilities.

In contrast, the Debt-to-Equity Ratio reveals a company's level of indebtedness. A high Debt-to-Equity Ratio can signal a company's reliance on debt financing, which may impact its creditworthiness.

As a credit analyst, understanding profitability ratios is crucial to determining a company's financial health. These ratios measure a company's ability to generate profit relative to revenue, balance sheet assets, and shareholders' equity.

Profitability ratios are split into margin ratios and return ratios. Margin ratios include gross profit margin, EBITDA margin, and operating profit margin. Return ratios include return on assets, risk-adjusted return, and return on equity.

Higher margin and return ratios indicate a company's greater ability to pay back debts. The gross profit margin, for example, reveals the amount of money a company has left after paying all direct costs of producing or purchasing goods or services.

The formula for gross profit margin is straightforward: subtract direct expenses or cost of goods sold (COGS) from net revenue, then divide by net revenues and multiply by 100%. This ratio is essential in evaluating a company's financial viability and comparing it to others in the industry.

Here's a breakdown of the key profitability ratios:

A company with a higher net profit margin than its competitor is usually more efficient, flexible, and able to take on new opportunities. The net profit margin reveals the amount of profit a company earns (usually after taxes) relative to its sales.

Investors and lenders rely on profitability ratios to help project whether stock prices are likely to appreciate and to determine the growth rate of corporations.

Leverage is a crucial aspect of a business's financial health, and credit analysts use leverage ratios to gauge a company's ability to repay its debts. These ratios compare the level of debt against other accounts on a balance sheet, income statement, or cash flow statement.

A lower leverage ratio indicates less leverage, which is what banks and creditors like to see. For example, if the debt to asset ratio is 0.1, it means that debt funds 10% of the assets and equity funds the remaining 90%.

Common leverage ratios include the debt to assets ratio, asset to equity ratio, debt to equity ratio, and debt to capital ratio. Here are some examples of what these ratios can tell us:

A lower leverage ratio means less asset or capital funded by debt, which is less risk for banks and creditors. Imagine lending someone $100 - would you prefer to lend to someone who already owes $1000 or someone who owes $100, given both make the same amount of money? It's likely you'd choose the person with less existing debt.

As a credit analyst, understanding cash flow measures is crucial in evaluating a company's financial health. Free Cash Flow (FCF) is a key measure, calculated by subtracting necessary investments in working capital and fixed assets, as well as net interest paid, from net income.

Cash flow measures like FCF, Funds From Operations (FFO), and Retained Cash Flow (RCF) focus on cash flows from operations, making them conservative and reliable indicators. These measures are essential in credit analysis, providing a clear picture of a company's cash generation ability.

Here are some common cash flow measures used in credit analysis:

These measures help credit analysts assess a company's ability to meet its debt obligations and make informed decisions about lending or investing.

RCF to Net is a ratio that assesses a company's leverage by comparing cash retained in the business to net debt.

This ratio is calculated by dividing Retained Cash Flow (RCF) by the difference between Debt and Cash and Marketable Securities.

A higher RCF to Net Debt ratio suggests the firm has retained more cash relative to its net debt, indicating better financial stability.

This ratio is useful for evaluating a company's ability to pay interest charges, as it takes into account EBITDA after capital expenditures are taken into account.

The RCF to Net Debt ratio is a key metric for investors and creditors, as it provides insight into a company's ability to manage its debt and maintain financial stability.

Cash Flow to Total Debt is a vital measure that helps investors and creditors understand a company's ability to repay its debts. It's calculated by dividing a company's cash flow from operations by its total debt.

This ratio is a form of coverage ratio, which means it shows how long it would take a company to repay its debt if it used all its cash flow to do so instead of investing in new assets or expanding its business. In other words, it's a measure of a company's debt burden.

A higher cash flow-to-debt ratio is generally better, as it indicates that a company has a strong ability to meet its debt obligations. Conversely, a lower ratio may indicate that a company is struggling to repay its debts.

Here's a simple way to think about it: if a company has a cash flow-to-debt ratio of 1.5, it means that for every dollar of debt, the company generates $1.50 in cash flow from operations. This suggests that the company has a strong ability to repay its debt and may even have some room to invest in new opportunities.

To illustrate this point, let's consider an example from a company with a cash flow-to-debt ratio of 1.2. This means that for every dollar of debt, the company generates $1.20 in cash flow from operations. While this ratio is still relatively healthy, it suggests that the company may be struggling to meet its debt obligations and may need to take steps to improve its cash flow or reduce its debt burden.

In summary, the cash flow-to-debt ratio is an important metric that helps investors and creditors understand a company's ability to repay its debts. By monitoring this ratio, companies can identify areas for improvement and take steps to strengthen their financial position.

The collection period is a crucial aspect of cash flow management. It measures how long customers take to pay their bills, and it's essential to keep it in check.

A longer collection period can tie up your cash for too long, making it difficult to pay suppliers on time. You may need to consider offering incentives or discounts to encourage customers to pay faster. In fact, most companies aim to keep their average days receivable between 30 and 45 days, but this can vary depending on the industry.

To calculate the average collection period, you'll need to determine the average accounts receivable. This is done by calculating the total amount of accounts receivable over a specific period and dividing it by the number of days in that period.

Here's a breakdown of the average collection period ratio:

* Average collection period ratio = Average accounts receivable / Average daily sales

For example, if your average accounts receivable is $100,000 and your average daily sales are $5,000, your average collection period ratio would be 20 days.

A shorter collection period is generally preferable, as it means you can access your cash more quickly and use it to drive your business forward. By keeping a close eye on your collection period, you can identify areas for improvement and make adjustments to optimize your cash flow.