Why are financial ratios important to creditors?

Why are financial ratios important to creditors?

Financial ratios analysis is the major factor in comparing or checking the financial condition of the businesses in the same industry.

As a creditor you need financial ratios to make the comparison of the customer business and make the decision about the future credit transaction with that business that whether to extend credit to customers, how much amount of credit to extend, and what are appropriate terms and conditions of sale.

As a credit professional you can use the following financial ratios to check the performance of the customers’ business, to find the potential risk and other threats that should be scrutinized by the credit manager.

Why are financial ratios important to creditors?
Liquidity Ratios:

Liquidity ratio tells us about how much easily a business can convert its current assets into cash. Laterally in business term, the liquidity means how much the company is capable of paying its debt and able to meets its current liability with cash and easily convert the assets into cash. Liquidity Ratios consist of Current Ratio and Quick Ratio.
Current ratio formula is a total current asset / current liability.
Quick ratio formula is (Current assets less inventories)
Leverage Ratios:

tells us about how much contribution of the stockholders and creditors in the business. By Leverage Ratio you can come to know how much business is relying on debt financing or equity financing, and to which extent the debt is used in the capital structure of the business. Leverage contains Debt to equity ratio and The Interest Coverage Ratio.
Debt to Equity ratio formula:

Total liabilities divided by total equity.
The interest coverage ratio formula: Earnings before Interest, Taxes, Depreciation and Amortization divided by Interest Expense.
Profitability ratios:

Profitability ratio uses to evaluate and examine the ability of the company in order to generate the income against cost associated with the generation of revenue. Profitability further categorized into the following:
• Gross profit margin
• Return on sales
• The return on assets
• return on equity
• return on assets
Efficiency ratios:

Tells us about how much the business is efficient in using of assets to generate the sales and profit.
Enlist below some ratios included in Efficiency ratio:
• Payables turnover ratio
• Inventory turnover ratio
• The Return on assets (ROA) ratio
• Asset turnover.

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