Key Financial Ratios for the Credit Department

by Michael C. Dennis, M.B.A., C.B.F.

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.

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 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 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 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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which of the following are factors in determining a company's credit rating

Which of the following are factors in determining a company's credit rating

A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. [ 1 ] Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.

Credit ratings are often confused with credit scores. Credit scores are the output of mathematical algorithms that assign numerical values to information in an individual's credit report. The credit report contains information regarding the financial history and current assets and liabilities of an individual. A bank or credit card company will use the credit score to estimate the probability that the individual will pay back loan or will pay back charges on a credit card. However, in recent years, credit scores have also been used to adjust insurance premiums, determine employment eligibility, as a factor considered in obtaining security clearances and establish the amount of a utility or leasing deposit.

A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects. A poor credit score indicates that in the past, other individuals with similar credit reports defaulted on loans at a high rate. The credit score does not take into account future prospects or changed circumstances. For example, if an individual received a credit score of 400 on Monday because he had a history of defaults, and then won the lottery on Tuesday, his credit score would remain 400 on Tuesday because his credit report does not take into account his improved future prospects.

An individual's credit score, along with his credit report, affects his or her ability to borrow money through financial institutions such as banks.

The factors that may influence a person's credit score are: [ 2 ]

In different parts of the world different personal credit score systems exist.

In the United States, an individual's credit history is compiled and maintained by companies called credit bureaus. Credit worthiness is usually determined through a statistical analysis of the available credit data.

  • A common form of this analysis is a 3-digit credit score. The most common form of credit score, known as the FICO credit score, however, the actual score is computed by credit bureaus. The term FICO is a registered trademark of Fair Isaac Corporation, which developed FICO and pioneered the credit rating concept in the late 1950s.

In Canada, individuals receive credit ratings such as the North American Standard Account Ratings, also known as the "R" ratings, which have a range between R0 and R9. R0 refers to a new account; R1 refers to on-time payments; R9 refers to bad debt.

In Australia, The Australian Government Office of the Privacy Commissioner provides information on how to obtain a copy of your credit report. Personal credit reports in Australia are generally required to be given free of charge.

There are two main credit reporting agencies, Veda Advantage and Dun & Bradstreet.

The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds. Credit rating is usually of a financial instrument such as a bond, rather than the whole corporation. These are assigned by credit rating agencies such as A. M. Best, Dun & Bradstreet, Standard & Poor's, Moody's or Fitch Ratings and have letter designations such as A, B, C. The Standard & Poor's rating scale is as follows, from excellent to poor: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, CC, C, D. Anything lower than a BBB- rating is considered a speculative or junk bond. [ 3 ] The Moody's rating system is similar in concept but the naming is a little different. It is as follows, from excellent to poor: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C.

A. M. Best rates from excellent to poor in the following manner: A++, A+, A, A-, B++, B+, B, B-, C++, C+, C, C-, D, E, F, and S. The CTRISKS rating system is as follows: CT3A, CT2A, CT1A, CT3B, CT2B, CT1B, CT3C, CT2C and CT1C. All these CTRISKS grades are mapped to one-year probability of default.

What Factors Determine a Firm’s Financing Choice?

The financial decisions of any type of an organisation can be divided into two categories. The first of these is concerned with spending – what spending decisions should be made in order to suffice a particular organisation’s future goals, which might be expressed in terms of profits, success in competition, new product development, growth and so forth. However, in order to realise these visions, each company necessarily needs to make decisions falling into the second category which is concerned with raising money for its spending.

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Spending financing represents an important issue in each company’s existence as the decisions within this category can have a wide variety of influences on the present and future of each organisation. A company’s financing decisions may be further subdivided into two categories: finance from internal capital (capital raised from the company’s earnings), and finance from external capital which is obtained from external investors in a wide variety of ways.

Since it is often not feasible for companies to finance their activities purely from internal sources as these do not allow the transfer of finance over time, they often choose external public for its higher flexibility in terms of obtaining financial resources at different times and for various purposes. This essay will mainly concentrate on determining the factors which influence a company’s decisions of raising funds for financing its further activities – obtaining external sources of capital.

External capital can be obtained in to major ways of issuing securities: the first of these is debt financing built on the basis of obtaining loans, leases, or issuing commercial paper, corporate bonds et cetera. This type of financing is tax-deductible. The second is equity financing through common stock, preferred stock or warrants. Equity financing is non-tax deductible and junior to debt financing – money can only be transferred to investors after debt payments have been made.

Large equity holders have the possibility to influence the company as they have the rights to become members of the board of directors which oversees the decision making process of the company and often appoints senior managers. Thus, as opposed todebt holders, equity holders can be seen as the formal owners of the company. Of course, the instruments of both debt and equity financing are not limited to the above mentioned ones – new instruments falling into either category are constantly developed through the mutual agreement of investors and companies.

Page 2 What Factors Determine a Firm’s Financing Choice? Essay

Further, companies may decide on the type of trade with securities they issue – this trade can be private or public. Private trade is represented by bank loans or other placements to sophisticated investor such as insurance companies, pension funds or wealthy individuals characterised by little liquidity and non-anonymity. Public trade is carried out on public markets accessible to virtually anyone, it is characterised by anonymity and comparatively more liquidity caused by the option of re-selling one’s securities to other individuals, companies etc.

The companies’ decisions as to where and how to obtain external finance will, logically, depend on the terms of individual agreements, on the companies’ gains from issuing each type of securities. On the other hand, investors’ decisions as to where and how to invest will depend on what they can gain for themselves. Thus, it is necessary to recognise that a mutual agreement needs to be reached through which both parties (and, of course, the intermediaries which make security trade possible) are able to gain from this type of ‘trade’.

Gompers and Lerner (2001) implicitly suggest the main factors on which investors will make their investment decisions are the size of the firm, its ‘age’, the levels of uncertainty and risk related to the environment (whether it be the industry, the market for the goods or services produced or the state in which the company is located) and the product, the historical development of the company’s performance, credit rating, and the information which investors and entrepreneurs possess related to the environment, product and possibilities of growth and profits.

The result of the assessment of these should then help investors make a decision as to whether to invest or to develop financial instruments which would exploit the state of the company and bring the highest yield on investment. Middleton et al. (1994) add to this that firms also evaluate financing options on the basis of interest rates which also represent an important factor for investors, the level of possible involvement of a potential investor in the company’s affairs, expenses related to loans etc.

From these accounts, we can observe several assumptions made about the financing choices of firms. It seems that that according to the above mentioned authors, the factors that can potentially determine a firm’s financing choice are embedded in the features of the firm itself, its environment and strategic choices it has made in the past. This observation follows from the fact that every firm seeks investors which will be willing to provide finance, and these investors decide on the basis of the type of the firm and the terms of the investment agreement.

The level of information about the firm’s future strategic decisions and access to this information also seem to be important for the financing decisions of companies. Thus, the underlying assumption here appears to be not only the investors’ ability to predict the future development of markets and environments of firms but mainly the possibility of assessing this future development on the basis of the past, the history of each firm.

Investors are assumed to ‘know’ what prospects of development a certain firm has and therefore how much risk is involved in the deal and subsequently negotiate terms of the potential agreement; this alleged ‘knowledge’ is supposed to stem from experience of similar situations in the past, from certain ‘stereotypes’ developed with the purpose of assessment. However, it is now necessary to pose ourselves the question whether the future (with which every investment is ultimately concerned) can really be assessed on the basis of the past and thus whether the factors that firms use to determine their financing choice can be assessed as such.

The main thrust here will lie mainly in the concept of information firms and their investors can possess, or claim to possess about the future, especially then information about a company’s growth, profits and return on investment since these are ones of the major endogenous variables in determining the price of securities on both private and public markets and thus in a firm’s financing decision.

Of course, it is possible to observe a company’s past behaviour, decision-making processes, profitability and so forth and making models suggesting the possible outcomes of future investment decisions. Yet these models still seem to be relying on heavy assumptions about the external factors of each company such as markets and the legal system in which a certain company is located. Of course, some of these (for example legal restrictions on investment) may remain stable.

Yet it is also necessary to understand that many of these factors are completely outside investors’ and firms’ influences and will thus make any decision concerned with financing not only difficult to make but also potentially inappropriate for changing environments which neither firms nor investor can affect. Considering this argument, the concept of the ability of information on the past to predict the future seems not entirely wrong, yet to a certain extent questionable.

Another factor which stems from the above argument and may play a role in terms of using information of a company’s performance or a model of a certain type of a company and its environment to make financing decisions is the role accounting plays in terms of assessing an organisation’s performance. As argued by Myddelton (2004), accounting does not represent a reflection of a company’s performance or profits. On the contrary, accounting creates these, it determines the way in which an organisation is seen not only by its owners and managers but also by outside observers including investors.

This argument is closely related to the concept of inscription explained by Latour (1992) which suggests that the way in which an initial observer (a accountant) creates a picture of the observed (a company’s performance) determines the way in which it will be seen by the individuals for whom this ‘picture’ is created, but also points out that there may still be differences in the views on the situation of the initial observer and these individuals caused by the differences between the personal explanations of the person who creates this picture and the one who receives it.

Applied to the sector of finance, this concept points out the fact that the way in which a company is assessed will have a major effect on its decisions in the future but also on the decisions of potential investor. This argument may fundamentally change our view on determining a firm’s finance choice. At this point, it is possible to argue that the factors used to determine this are not self-explanatory, rational entities applicable to any company in any situation, but that these factors themselves are determined by the way in which we assess a given business.

The distinction may thus now be made between the factors determining a firm’s financing choice and the effects these factors have. Considering the above argument, we come to recognise that it is true that financial decisions are often made on the basis of the already mentioned concepts such as a firm’s past performance, its size, the type of product it offers, the amount of research and development in the area etc. Yet when observing these, we often forget that the way in which we observe the firm under consideration is also dependent on our way of observing it.

Thus rule will also apply to the environment of this organisation and external factors influencing it such as other firms or the legal system. The observation of these may often lead us to believe that these are the actual factors determining the firm’s financing choice. However, it is absolutely essential that we take into account the way in which information is constructed through the process of inscription. It is this very process of construction which will determine the way we evaluate a company and subsequently make decisions related not only to finance but also to other factors of organisational life.

Only this process can aid our understanding the true core of the factors determining a firm’s behaviour, as opposed to a pure observation of the effects the construction of organisational information has. To conclude, the evaluation of the basic assumptions underlying the analysis of organisational decision making related to finance is crucial to develop our understanding of the factors which determine a firm’s financing choice.

The main argument is that not only information related to the past may be invalid when applied to the predictions about the future, but mainly that the way in which we obtain this information and the way in which we comprehend it will be the key factor in our decision-making. Thus, it becomes clear that it is necessary to not only consider the basic facts about the organisation but also the way in which these facts were created in order to obtain a clear view on how an organisation’s financing decision is made.

Factors Determining Working Capital Requirement

Working capital requirement is influenced by various factors. In fact, any and every activity of a company affects the working capital requirements of the company. The magnitude of influence may be different. Some important of them are listed below:

Factors Influencing Working Capital Management

The management of working capital is completely different from industry to industry. A simple comparison of the service industry and manufacturing industry can clarify the point. In a service industry, there is no inventory and therefore, one big component of working capital is already avoided. So, the nature of the industry is a factor in determining the working capital requirement.

Seasonality of Industry and Production Policy

Businesses based on seasons like manufacturing of ACs whose demand peaks in summer and dips in winter. The requirement of working capital will be more in summer compared to winter if they are produced in the fashion of their demand. The policy of producing throughout the year can smoothen the fluctuation of working capital requirement.

If the industry is competitive, quick response to customer needs is compulsory and therefore a higher level of inventory is maintained. Liberal credit terms are also mandatory with good service to survive in the market. So, higher the competition, higher would be the requirement of working capital.

The production cycle time refers to the time required for converting the raw materials into finished goods. Higher, this time, higher would be the time of blocking funds in the working capital.

Liberal credit policy demands a higher level of working capital and tight credit policy reduces it.

Some industries are static and others are growing. Obviously, growing industry grows the requirement of working capital also as compared to static industry.

If the raw material supply is not smooth for any reason, companies tend to store more of raw materials than needed and that increased requirement of working capital.

Profit or retained earnings are one of the sources of working capital for the business. It will depend on net cash profits as to how much working capital financing is required from external sources.

Taxes are often paid in advance. This also blocks a part of working capital. Depending on the tax environment of the industry, working capital needs are also affected.

Dividend policy determines the level of retained profits with the business and retained profits are also used for working capital. This is how; dividend policy affects the need for working capital.

The price levels of inventory and other expenses such as labour rates etc increase the working capital requirement. If the company also is able to increase the price of their finished goods, it reduces this impact.