Describe the key ratios to analyze creditworthiness
The process of evaluating credit worthiness demands companies to scrutinize verifying defaults that are associated with the bond issuer. Crediting agencies should conduct credit analysis in order to implement bond rating. Conducting such evaluations frequently is essential because company’s credit worthiness varies with the market forces. Credit analysis attracts various benefits to the investors, which includes providing them with accurate information for making informed decisions. For example, an investor can invest on the particular after establishing that the bond rating is decreasing. This is because investing in such bonds would enable investors to contain the lower interest rate that may affect company’s activities (Fridson & Alvarez, 2011). Alternatively, if the results of credit analysis show that, the bond rate is likely to increase; the investor will have more interest for purchasing such bonds because this has potential of lowering risks as it gives him or her higher coupon.
Remarkably, there are different ratios used to analyze the creditworthiness. These ratios include liquidity ratios, profitability, leverage and efficiency activity or turnover ratio. Any pair of number can result into computation of a ratio including large quantity of variables found in the financial statement. The above-mentioned ratios highlight the ratio that most companies apply while evaluating the worthiness of their customers. However, the analysis that they employ in evaluating the credit worthiness depends with the personal or company driven procedures as most analysts apply the one that they feel it is more comfortable with them (Coyle, 2000).
Initially, there are liquidity ratios, which include the entail the working capital. This ratio compares both the current liabilities and assets thus acting as a liquid reserve with the aim of satisfying contingencies and uncertainties. If the company is unable to borrow the working capital within a short notice, then it incurs a high working capital balance. The commonly used formula in calculating working capital is current asset minus current liabilities. Additionally, the liquidity ratios also contain the decisive test or the quick ratio used in measuring the business’s liquidity position. This ration also compares the cash equivalents, cash plus and account receivables to the current liabilities. Consequently, there is a difference between in between the current ratio and the quick ratio in that the quick ratio avoids incorporating the inventory and prepaid expenses in calculation while the current ratio incorporates them. In calculating the quick ration, the company adds cash, marketable securities and accounts receivables then they divide them with current liabilities (Fridson & Alvarez, 2011).
Current ratio is also part of liquidity ratios. It is used to offer direction to the liquidity of the business through comparing both the current assets and liabilities. The current assets of any given business entail cash, marketable securities, inventories and the account receivables. However, the current liabilities include the account payable, current maturities obtained in long-term debts, income taxes and accrued expenses due in a year. Therefore, this makes many companies to prefer having a dollar of current asset for every dollar of the current liabilities. The current ratio keeps fluctuating from industry to industry. When the current ratio is higher compared to the industry average, then this shows the availability of redundant assets. On the contrary, when the current ratio is lower than the industry average, then there is lack of liquidity. The formula of calculating the current ratio includes dividing the current assets with current liabilities. Liquidity ratios also entail the cash ratio, which aims at showing the conservative view of liquidity, which occurs when the company pledges its receivables, inventories or when there is liquidity problems affecting both the inventories and receivables. In calculating the cash ratio, the company adds cash equivalent with marketable securities then divide them with current liabilities (Langohr & Langohr, 2008).
In addition, profitability ratios can be used in analyzing credit worthiness. These includes ratios such as the net profit margin, which is a net income dollars measure generated by each dollar sales. To obtain this, the company divides net income with net sales. There is also the return on assets, which refers to the measure of the company’s ability to use its assets in creating profits. To obtain this, the company divides the net income with total sum of beginning and ending total asset divided by two. Thereafter, there is the operating income margin, which is the operating income resulting from each dollar of sales. To obtain this, the company divided the operating system with the net sales (Fridson & Alvarez, 2011).
Remarkably, the financing leverage ratio can be essential in analyzing credit worthiness. These ratios entail the total debts to assets, which indicate the capability of a company to absorb asset reductions arising from the losses. To obtain this, the company divides the total liabilities with the total assets. It further encompasses the capitalization ratio showing long time debts and to obtain it, the company divides long-term debts with the sum of long-term debt with the owner’s equity. There is the debt equity obtained by dividing total debt with total equity and it shows the creditor’s protection in case of insolvency. The financing leverage ratios also encompass the interest coverage ratio, which aims to show the capacity of a company to attain the payments interest (Langohr & Langohr, 2008).
Finally, efficiency ratios can be effective in analyzing credit worthiness. These ratios include the cash turnover whose main aim is to measure the effectiveness of a company in using its cash. To obtain this, the company divides total net sales with cash. Total asset turnover can be effective in analyzing credit worthiness because it focuses on analyzing the activities of the assets and the manner in which a business can generate sales by using assets. It also entails the fixed asset turn over with the aim of measuring the capacity utilization as well as the quality of fixed assets. To obtain this, the company divides net sales with the net fixed assets. Additionally, there is the account receivable turnover with the aim of showing liquidity of the company’s receivables. In calculating this, the company divides the net sales with the average gross receivables. Finally, there is the accounts receivable turnover in days, which shows liquidity of the receivables in days within a company. Companies obtain this by dividing the average gross receivables with the annual net sales divided by 365 (Kricheff, 2012).
How to conduct a financial credit analysis
Credit analysis refers to the method, which individuals or companies apply in determining the worthiness of a business or organization. For example, this can be through analyzing the audited financial statement of a large company after it had issued bonds. Consequently, it is possible for a bank to analyze the financial statement of an individual or small business before deciding to allocate them with commercial loan. In credit analysis, there are different financial analysis techniques such as ratio and trend analysis together with implementation of projections and internal analysis of the cash flows. Additionally, credit analysis entails the examination of the collateral as well as relevant sources of repayment and it considers the credit history and management ability (Fridson & Alvarez, 2011).
Remarkably, before banks approve any commercial loan, they consider different factors with the major one being the borrower’s cash flow. The bank considers the repayment ability and it conducts this by ensuring that the credit analyst in the bank measures the cash that the borrower business created. Thereafter, the debt service representing the coverage ratio then divides the cash flow amount by the debt service required to be met. Incredibly, most bankers prefer the debt service coverage to be 120% and more because this indicates that, there is extra cushion and the business can afford the requirements of the debt. Additionally, companies conducting the credit analysis also use the debt service in the coverage ratio. This refers to the ratio of net operating income compared to the debt payments within the investment in real estate. This type of credit analysis is commonly applied in the measuring of properties’’ that produce income so that they can offer enough h revenue capable of covering the monthly mortgage payment. Therefore, the high the ratio appears to be, the easier it is for the company to borrow money used in the property investment. Interestingly, the same approach is commonly applied in corporate finance expressed as the least ration, which is acceptable to the lenders such as loan condition, loan covenant or the condition of the default (Gibson, 2010).
Notably, some lenders use the five C’s while examining the business credit analysis. These include the capacity, capital, collateral, conditions and character. Initially, capacity is imperative in this process because it explores the methods that the interested business will apply in repaying the loan and trends of their successfulness in repaying the past loans. Capital draws attention on ensuring that the interested business has enough capital, which will enable it to repay the loan. In collateral, the lender considers the type of security that it needs before giving out the loan. Concurrently, condition in the five C’s represents the purpose of the loan and its benefits to the businesses. Finally, character refers to the quality that the lender gets from the impression of the business. Therefore, it is imperative for every lender company to consider the discussed C’s before conducting any business credit analysis (Joseph, 2007).
The lenders also consider essential documents while conducting a loan analysis. Initially, they ensure that they analyze the personal financial statement, which draws attention on the net worth of all major holders of the business equity. Thereafter, the lender should consider analyzing the business balance sheet as it indicates the state in which the borrower’s business is like. The profit and loss statement is also imperative in credit analysis because it highlights both the profits and losses of a business throughout the year. The lender will also use the statement of the cash flow in order to determine the manners in which the business receives and spends cash during its operations. Finally, during credit analysis, it is vital for the lender to conduct a ratio analysis so that it can predict the future of a business and determine whether it has value or not (Gibson, 2010). This step entails the application of varying ratios such as profitably to determine the profit that the business makes after deducting all expenses. It also includes leverage ratios, which describe the total amount that the business is financed by debt in relation to the amount financed by equity (Gibson, 2010).
Coyle, B. (2000). Corporate credit analysis. Chicagol: Glenlake Pub. Co.
Fridson, M. S., & Alvarez, F. (2011). Financial statement analysis: A practitioner’s guide. Hoboken, N.J: Wiley.
Gibson, C. H. (2010). Financial Reporting and Analysis: Using Financial Accounting Information (Book Only). S.l.: South Western Educational Pub.
Joseph, C. (2007). Credit risk analysis: A tryst with strategic prudence. New Delhi: Tata McGraw-Hill.
Kricheff, R. (2012). A pragmatist’s guide to leveraged finance: Credit analysis for bonds and bank debt. Upper Saddle River, N.J: FT Press.
Langohr, H. M., & Langohr, P. T. (2008). The rating agencies and their credit ratings: What they are, how they work and why they are relevant. Chichester, England: Wiley
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