Ratios used in Credit Analysis

August 10, 2012

Financial ratios are a means of evaluating a companys performance or health using its financial statements. We will discuss few ratios which are predominantly used by credit rating analyst or credit rating agencies to gauge solvency and cash flow related aspects of a business/company. Even an equity investor can use this to test whether a company is effective managing its business. Ratios are classified into different variants. They are: Liquidity Ratio Asset Turnover Ratio

Financial Leverage Ratio/Gearing Ratio Profitability Ratio Dividend Policy Ratio Cash Flow Ratio Investment Valuation Ratio

There may be more bifurcation. But for now lets read above listed ratios. We wont discuss the non-bold ratios. Liquidity Ratio: Liquidity ratios attempt to measure a companys ability to pay off its short-term debt obligations. 1. Current Ratio: The concept behind this ratio is to ascertain whether a companys short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better. Current Ratio = Current Asset / Current Liabilities 1. Quick Ratio: Quick Ratio is also known as Acid Test Ratio. Quick Ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position. Quick Ratio = (Cash Equivalents + Liquid Investment + Accounts Receivable) /

Current Liabilities Gearing Ratio: Financial Leverage Ratios provide an indication of the long term solvency of the firm unlike liquidity ratios which are concerned with short term assets and liabilities. It is also said to be a measure of financial leverage, demonstrating the degree to which a firms activities are funded by owners funds versus creditors funds.

1. Debt to Equity Ratio: The most common Gearing ratio is Debt-to-Equity ratio. A high Debt-to-Equity ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. In a business downturn, such companies may have trouble meeting their debt repayment schedules, and could risk bankruptcy. Debt Equity Ratio = Total Debt/ Total Equity 2. Times Interest Earned: The Times Interest Earned ratio indicates how well the firms earnings can cover the interest payment on its debt. It is also known as Interest Coverage Ratio. Higher the ratio better is the business. Interest Coverage = (EBIT)/Interest & Finance Charges 3. Debt-Asset Ratio: Debt by Asset ratio here again indicates the level of leverage the business is facing. Higher the ratio more leveraged the business is. Debt-Asset Ratio = Total Debt / Total Assets 4. Capitalization Ratio: Capitalization ratio again deciphers the financial leverage of a firm.

Capitalization Ratio = (LT Debt) / (LT Debt + Preferred Stock + Equity) Profitability Ratio: This ratios show how profitable is the business. These ratios examine the profits made by a firm and compare these figures with the size of the firm, the assets employed by the firm or its level of sales.

1. Gross Profit margin: Gross profit is profit before indirect expenses. High Margin is preferable. Gross Profit Margin = Gross Profit / Operating Income 2. Net Profit Margin : This Margin indicates profitability after all cost have been included. High Margin is preferable. Net Profit Margin = PAT (Profit After Tax) / Operating Income 3. Return on Capital Employed (ROCE) : ROCE is the % return on the capital invested in the business. It is a ratio which looks at how effectively a company uses its capital. It is often seen as a prime ratio since it provides a direct measure of the main task of management i.e. to maximise the return on capital invested. High number is preferred.

ROCE = PBIT / (Total Debt +Tangible Net worth +Deferred Tax Liability CWIP) Cash Flow Ratio : Cash flow analysis uses ratios that focuses on cash flow and how solvent, liquid, and viable the company is. Here are the most important cash flow ratios with their calculations and interpretation.

1.Fund Flow From Operation / Interest 2.Fund Flow from Operations/Total Debt 3.Retained Cash Flows/Total Debt The above ratio may vary from industry to industry. They can be proper used to compare business in same industry as we know ratio of an Infra company would differ with FMCG in terms of above ratios. Higher the above cash flow ratio better the business.