Unlocking the Financial Story: The Power of Ratios in Credit Analysis

Have you ever wondered how lenders decipher a business’s financial health? Just as a doctor
uses vital signs to gauge a patient’s well-being, financial analysts use key ratios to understand a
company’s economic condition. These ratios are numbers and the narrative of a borrower’s past
decisions and future potential. Let’s dive into the top four ratios that can quickly tell us this
financial story.

Ratios are an effective way to track and trend a borrower’s financial performance. Trend analysis
should be utilized for historical trends to evaluate projected trends, particularly during a
borrower’s growth strategy. When analyzing new credit or renewals, these top four common
ratios can tell a story quickly.

CURRENT RATIO = Current Assets/Current Liabilities

The Current Ratio, also called the Working Capital Ratio or Liquidity Ratio, is a pivotal
indicator of a borrower’s liquidity. It gauges the borrower’s capacity to convert short-
term assets into cash to fulfill its current liabilities or short-term obligations. A higher
current ratio is generally perceived as more favorable.

QUICK RATIO = (Current Assets – Inventory – Prepaids)/Current Liabilities

This is a much more precise ratio to determine the borrower’s ability to service short-term
obligations or current liabilities. By subtracting inventory and prepaid, the ratio reveals
the borrower’s real-time ability to pay obligations without liquidating assets before
paying short-term obligations.

DEBT-to-ASSET RATIO = Total Liabilities/Total Assets

A leverage ratio is a crucial metric that reveals how much a borrower is leveraged to its
assets. It also provides insights into the remaining balance sheet capacity for future
borrowing to facilitate growth or address a financial problem, calculated as 1 – Debt-to-
Asset Ratio = Excess Balance Sheet Capacity.

SOLVENCY RATIO = Total Net Income + Depreciation/Total Liabilities

The solvency ratio indicates the borrower’s ability to meet its global liabilities in the
foreseeable future. Caution: Each industry has an acceptable benchmark.

These ratios are powerful tools for telling the “financial story” of a borrower. They provide
quick insights into various aspects of financial health and are essential for informed decision-
making in credit analysis. Establishing benchmarks for these ratios can guide underwriting and
help identify areas requiring further investigation or action. Considering the context and industry
standards when interpreting these ratios is essential, as they can vary significantly across
different sectors.