RATIOS USED FOR CREDIT ASSESSMENT

  RATIOS USED FOR CREDIT ASSESSMENT

A. LIQUIDITY RATIO
1. Current Ratio
Formula: Current Assets/Current Liabilities
Current asset and current liabilities are those receivable or payable respectively within a
period of 12 months or one operating cycle.
It is a measure of liquidity of the company. A company with a current ratio less than one
does not have the capital on hand to meet its short-term obligations if they were all due
at once, while a current ratio greater than one indicates that the company should be
able to remain solvent in the short-term.
The ratio in standalone basis will not provide a meaningful interpretation. An in-depth
analysis of the quality of the current assets and liabilities will provide a better picture of
the company’s liquidity position.
For example, a company may have a very high current ratio but their accounts
receivable is low quality. Perhaps they have not been able to collect from their
customers quickly which may be hidden in the current ratio. Further If inventory is
unable to be sold, the current ratio may still look acceptable, but the company may be
headed for default.
A current ratio less than one would not be concerning if the company has a much higher
receivables turnover than payables turnover. For example, retail companies collect very
quickly from consumers but have a long time to pay their suppliers.
2. Liquid ratio / Acid Test ratio / Quick ratio
Formula: (Current Assets – Inventory – Prepaid expenses) / (Current Liabilities –
Bank borrowings)
The ratio indicates the backing available to liquid liabilities in the form of liquid assets.
Liquid assets are those current assets which can be converted to cash without reduction
in value and almost immediately.
B. TURNOVER RATIO
1. Fixed Assets turnover ratio
Formula: Net Sales/Fixed Assets (WDV)
The ratio indicates the capability of organization to achieve sales viz-a-viz the
investment in fixed assets. Higher the ratio, better the efficiency of the organization.

2. Current Assets turnover ratio
Formula: Net Sales/Current Assets
The ratio indicates the capability of organization to achieve sales viz-a-viz the
investment in current assets. Higher the ratio, better the efficiency of the organization.
3. Working capital turnover ratio
Formula: Net Sales/Working capital
The ratio indicates the capability of organization to achieve sales viz-a-viz the
investment in working capital. Higher the ratio, better the efficiency of the organization.
4. Inventory/Stock turnover ratio
Formula: Cost of goods sold/Average inventory
Net sales/Average Inventory
Cost of goods sold/Cost inventory
Net sales/Closing inventory
In normal condition, a higher ratio is desirable. However low level of inventory may also
lead to the company not being able to adhere to delivery schedules. Though low level of
inventory maintenance will reduce the carrying cost and thereby higher profits,
sometimes higher maintenance of inventory may also lead to increase in volume of
sales thereby leading to higher profits.
5. Debtors Turnover ratio
Formula: Net Credit sales/Closing sundry debtors
The average collection period computed as above should be compared with the normal
credit period allowed to customers. If the average collection period is more than the
normal credit period, it may indicate over investment in debtors, over extension of credit
period, liberalization of credit terms and ineffective collection procedure among others.
6. Capital turnover ratio
Formula: Sales/Capital Employed
The ratio indicates the efficiency of the organization in respect of capital utilization.
Higher ratio is desirable.

C. SOLVENCY RATIO
1. Debt Equity ratio
Formula: External/Shareholders funds’
Long term liabilities/Shareholder Funds
If the ratio is higher, it indicates higher external borrowings, and it increases the risk of
investment in such an organization. The best possible to way to increase earnings to
shareholders is to borrow funds from outside because
(i) Cost of equity is high
(ii) Return on investment paid to creditors is a tax-deductible expenditure
2. Proprietary ratio
Formula: Total Assets/ Owners funds
Fixed Assets/Owners funds
Current Assets/Owners funds
The ratio indicates the extent to which the owner’s funds are sunk in different kind of
assets. If owners’ funds exceed fixed asset, it indicates owner’s funds are used to
finance current assets and if vice-versa, it indicates that fixed assets are financed by
long term or short term creditors.
3. Fixed assets/Capital Employed ratio
Formula: (Fixed assets/Capital Employed) X 100
A high ratio indicates a major portion of long term funds is being used for fixed assets
rather than working capital. A high ratio coupled with declining current ratio indicates
urgent need for introduction of long term funds for financing working capital.
4. Interest coverage ratio.
Formula: Profit before Interest and taxes / Interest charges
The ratio indicates protection available to the lenders of long term capital in the form of
funds available to pay interest charges. Though a high ratio is desirable, a very high
ratio indicates under-utilization of borrowing capacity of the organization.

5. Debt service coverage ratio.
The ratio is calculated in two ways, Gross DSCR and Net DSCR
Formula:
Gross DSCR = (Cash accruals + Term loan interest)/ (Term loan installment +
Term loan interest
Net DSCR = Cash accruals / Term loan installment
The ratio indicates the level of serviceability of debt viz-a-viz the cash accruals
generated by the company. The higher the ratio, better the company’s financial position
to service interest and installment.
D. PROFITABILITY RATIO
1. Gross profit ratio
Formula: (Gross profit/Net sales) X 100
By comparing Gross Profit percentage to Net Sales we can arrive at the Gross Profit
Ratio which indicates the manufacturing efficiency as well as the pricing policy of the
concern.
Alternatively, since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also
be interpreted as below:
Alternate formula = [ (Sales – Cost of goods sold)/ Net Sales] x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.
2. Net Profit ratio
Formula: (Net profit/Net sales) X 100
The ratio indicates that portion of the sales which is available to the owners after the
consideration of all types of expenses and costs, either operating or non-operating,
normal or abnormal. A high ratio is considered desirable.
3. Operating ratio
Formula: {(Manufacturing cost of goods sold + operating expenses) / Net sales}
X100
A high ratio indicates that only a small margin of sales is available to meet expenses in
the form of interest, dividend and other-operating expenses.

E. OVERALL PROFITABILITY RATIO
1. Return on assets (ROA)
Formula: (Net profit/Assets) X 100
It measures the profitability of investments and a higher ratio is desirable. The ratio
does not indicate the profitability of various sources of funds, which finance the total
assets.
2. Return on capital employed (ROCE)
Formula: (Net profit + Interest on long term sources) / Capital employed
The ratio indicates the profitability of capital employed. A higher ratio indicates a better
and profitable use of long term funds of owners and creditors.
3. Return on shareholders’ funds
Formula: (Net profit after taxes + total shareholders’ funds) X 100
The ratio indicates whether the firm has earned sufficient returns for its shareholders or
not. A higher ratio is desirable.
F. MISCELLANEOUS RATIO
1.Capital gearing ratio.
Formula: Fixed Income Bearing securities / Equity capital
A high ration indicates that in the capital structure, fixed income bearing securities are
more in comparison to the equity capital and company will be highly geared which is
considered a highly unstable situation. A high gearing ratio is advantageous from the
equity shareholders’ point of view.
2. Earnings per share (EPS)
Formula: (Net Profit after taxes – Preference dividend) / Number of equity shares
outstanding
The ratio is calculated based on current profit and not based on retained profit. The ratio
only indicates the profits available to shareholders on per share basis and not the
quantum of earnings paid to owners by way of dividend or how much of earnings is
retained in the business.

3. Price earnings ratio (P/E ratio)
Formula: Market price per share / Earning per share
The ratio measures the expectation of the investors and an ideal investor will compare
between the current price and future EPS also.
4. Dividend payment ratio (D/P ratio)
Formula: (Dividend per share / Earning per share) X 100
The ratio indicates the policy of the management to pay cash dividend.
1 - D/P ratio indicates the retained profits in the business available for future expansion.