Which financial ratios should credit professionals rely on the most?
a) Profitability ratios
b) Liquidity ratios
c) Management Efficiency ratios
d) Leverage ratios
e) Valuation & Growth ratios
There really is no right answer. In my view, it’s wide and various as to which ratios to use, especially as it’s dependent upon the detail of information available.
If a credit manager has the time and expertise to work with any of these ratios, they will give a fair amount of insight into the financial status of a potential client. Personally, I’m partial to liquidity ratios. If a company can’t pay its short-term bills right from the get go, there really is little point in granting credit.
Following below is a list of the major ratios for your reference.
a) Profitability Ratios
Gross Profit Ratio = Gross Profit ÷ Net Sales — Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus sales returns, discounts, and allowances) minus cost of sales.
Return on Sales = Net Income ÷ Net Sales — Also known as “net profit margin” or “net profit rate”, it measures the percentage of income derived from dollar sales.
Return on Assets = Net Income ÷ Average Total Assets — It’s the measure of the return on investment. ROA is used in evaluating management’s efficiency in using assets to generate income.
b) Liquidity Ratios
Current Ratio = Current Assets ÷ Current Liabilities — Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable securities, current receivables, inventory, and prepayments).
Acid Test Ratio = Quick Assets ÷ Current Liabilities — Also known as the “quick ratio”, it measures the ability of a company to pay short-term obligations using the more liquid types of current assets or “quick assets” (cash, marketable securities, and current receivables).
Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities — Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash.
Net Working Capital = Current Assets – Current Liabilities — Determines if a company can meet its current obligations with its current assets and how much excess or deficiency there is.
c) Management Efficiency Ratios
Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable — Measures the efficiency of extending credit and indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process.
Days Sales Outstanding = 365 Days ÷ Receivable Turnover — Also known as “receivable turnover in days.” It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better.
Inventory Turnover = Cost of Sales ÷ Average Inventory — Represents the number of times inventory is sold and replaced. A high ratio indicates that the company is efficient in managing its inventories.
Days Inventory Outstanding = 365 Days ÷ Inventory Turnover — Also known as “inventory turnover in days”. It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO the better.
Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable —Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes.
Days Payable Outstanding = 365 Days ÷ Accounts Payable Turnover — Also known as “accounts payable turnover in days.” It measures the average number of days spent before paying obligations to suppliers.
Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding —
Measures the number of days a company makes 1 complete operating cycle, i.e. purchase the merchandise, sell the items, and collect the amount due. A shorter operating cycle means that the company generates sales and collects cash faster.
Total Asset Turnover = Net Sales ÷ Average Total Assets — Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.
d) Leverage Ratios
Debt Ratio = Total Liabilities ÷ Total Assets — Measures the portion of company assets that is financed by debt (obligations to third parties).
Equity Ratio = Total Equity ÷ Total Assets — Determines the portion of total assets provided by equity (i.e. owners’ contributions and the company’s accumulated profits).
Debt-Equity Ratio = Total Liabilities ÷ Total Equity — Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a leveraged firm; less than 1 implies that it is a conservative one.
Times Interest Earned = EBIT ÷ Interest Expense — Measures the number of times interest expense is converted to income, and if the company can pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.
e) Valuation and Growth Ratios
Earnings per Share = (Net Income – Preferred Dividends) ÷ Average Common Shares Outstanding — EPS shows the rate of earnings per share of common stock. Preferred dividends are deducted from net income to get the earnings available to common stockholders.
Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share — Used to evaluate if a stock is over or underpriced. A relatively low P/E ratio could indicate that the company is underpriced. Conversely, investors expect high growth rate from companies with high P/E ratio.
Dividend Payout Ratio = Dividend per Share ÷ Earnings per Share —Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year’s operations.
Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share — Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is attractive to investors who are after dividends rather than long-term capital appreciation.
Book Value per Share = Common SHE ÷ Average Common Shares — Indicates the value of stock based on historical cost. The value of common shareholders’ equity on the books of the company is divided by the average common shares outstanding.