Using Financial Analysis to Assess Business Credit Status

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  • 0:01 Calculating Business…
  • 1:08 Liquidity Ratios
  • 3:04 Leverage Ratios
  • 5:05 Debt Service Coverage Ratio
  • 6:09 Putting it All Together
  • 6:25 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

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.

Liquidity Ratios

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

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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