Deborah teaches college Accounting and has a master's degree in Educational Technology.
A lender needs to ensure that a company to whom it extends credit will be able to repay the amounts it borrows. In this lesson, you'll learn how a lender assesses a business's credit status.
Calculating Business Credit Status
Fred's Fabulous Furniture has approached Mr. B. Nice of the Friendly Bank for a loan. Before granting the loan, Mr. B. Nice needs to determine the credit status or creditworthiness of Fred's Fabulous Furniture. Creditworthiness involves determining whether or not the business is in a good position to repay its borrowings. Mr. B. Nice wants to ensure that Fred's Fabulous Furniture will be able to repay the interest as well as the full amount of the loan, known as the principal amount, at maturity.
Calculating financial ratios can be an effective tool in assessing the creditworthiness of a company. For example, Mr. B. Nice should calculate a combination of liquidity and leverage ratios as well as the debt service coverage ratio when determining Fred's Fabulous Furniture's ability to repay its borrowing. Liquidity ratios measure a company's capability to pay off its short-term borrowing when it is due. Leverage ratios measure how much of a company's capital consists of borrowing as well as its ability to repay amounts it has borrowed.
Let's take a look at these different ratios in more detail.
Mr. B. Nice would want to assess two liquidity ratios: the current ratio and the quick ratio. The current ratio measures the ability of the company to pay its short-term debts and its formula is:
current ratio = current assets / current liabilities
Assets are items of value that a company owns, and liabilities are items that a company owes, such as a loan. Let's assume that the financial statements for Fred's Fabulous Furniture reveal current assets of $500,000 and current liabilities of $250,000. The current ratio would be 2 to 1 (or $500,000 / $250,000), which means that Fred's Fabulous Furniture has $2.00 in current assets to pay every $1.00 in current liabilities. At a minimum, this ratio should be at least 1 to 1 to pay current borrowing. The current ratio for Fred's Fabulous Furniture is favorable.
The quick ratio is a refinement of the current ratio as the effects of inventory are removed. This ratio also measures a company's short-term debt paying ability. The formula for the quick ratio is:
quick (or acid-test) ratio = (current assets - inventory) / current liabilities
The financial statements for Fred's Fabulous Furniture shows current assets = $500,000; current liabilities = $250,000; and inventory = $75,000. The quick ratio would be 1.70 to 1 (or ($500,000 - $75,000) / $250,000), which means that Fred's Fabulous Furniture has $1.70 in highly liquid assets to pay every $1.00 of current borrowing. It is desirable for this ratio to be at least 1 to 1, so Fred's Fabulous Furniture's result is favorable.
Leverage ratios measure the amount of a company's debt. If a company has borrowed heavily, it is said to be highly leveraged and would be at greater risk of not being able to pay back its borrowings. Mr. B. Nice would want to calculate the debt-to-equity and the interest coverage ratios for Fred's Fabulous Furniture.
The debt-to-equity ratio measures how much debt the company used to finance the purchase of its assets when compared with the amounts contributed by owners, which is known as equity. The formula for calculating the debt to equity ratio is:
debt-to-equity ratio = total debt / total equity
Let's assume that Fred's Fabulous Furniture has debt of $600,000 and equity of $800,000. Its debt-to-equity ratio would be 0.75 (or $600,000 / $800,000). This means that Fred's Fabulous Furniture has $1.00 of equity for every $0.75 debt. This would be a favorable result.
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When a company borrows money, it must pay interest on a regular basis regardless of whether or not it has the cash. The interest coverage ratio measures how easy it is for a company to pay the interest charges on its outstanding borrowing. The formula for calculating the interest coverage ratio is:
interest coverage ratio = earnings before interest and taxes (or EBIT) / interest expense
Let's assume that Fred's Fabulous Furniture paid $150,000 in interest expense last year, and its earnings before interest and taxes were $775,000. Its interest coverage ratio would be 5.17 (or $775,000 / $150,000), which indicates a strong ability to pay interest charges when they become due as the company has 5.17 times more revenue being earned than interest payments being paid. Although a measure above 1.0 is considered acceptable, most lenders want to see a ratio of at least 1.50 before providing a loan.
Debt Service Coverage Ratio
Another important measure of a company's creditworthiness is its debt service coverage ratio, which indicates the company's ability to manage both its current debt and the interest it is paying on it. This measure is a refinement of the interest coverage ratio and is a good indicator of potential default (or failure to pay) on a borrowing by a company. The formula for calculating the debt service coverage ratio is:
debt service coverage ratio = net income / total debt service
Let's assume that Fred's Fabulous Furniture had net income of $700,000 and its total debt service (consisting of principal and interest payments) was $490,000. Its debt service ratio would be 1.43 (or $700,000 / $490,000), which means that the company has $1.43 of net income to cover every $1.00 of interest and principal repayments. A measure above 1 indicates a healthy company, so we can conclude that Fred's Fabulous Furniture is in a good position to repay its debts.
Putting It All Together
Fred's Fabulous Furniture is in a great position to assume more debt. Its creditworthiness is favorable as evidenced by its leverage, liquidity, and debt service coverage ratios. Friendly Bank would have no reservations about providing them with a loan to finance their expansion.
A company's creditworthiness can be assessed using its financial information to calculate liquidity ratios, which illustrate a company's ability to pay its short-term borrowing when it is due; leverage ratios, which measure how much of its capital consists of borrowing and its ability to repay its debts; and the debt service coverage ratio, which measures a company's ability to manage its current debt and the interest it is paying on it. As with any decision, financial analysis should be supplemented with additional analysis before making a final decision.
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