Financial ratio analysis provides insights into a company's profitability, leverage, and liquidity by evaluating both current performance and trends over time. Financial ratios also serve as benchmarks, providing comparisons across time periods, competitors, and industry standards.
While numbers on financial statements tell part of the story, ratios allow you to “read between the lines” and uncover critical insights that might not be immediately visible. Understanding and interpreting these ratios is the foundation of effective financial analysis and decision-making.
Article Topics
Types of financial ratios
Interpreting financial ratios
Key financial ratios for credit analysis
Types of financial ratios
Financial ratios are derived from spreading financial statements—specifically, the balance sheet, income statement, and cash flow statement. These ratios offer quantitative insights into a company’s liquidity, leverage, profitability, and efficiency.
Liquidity Ratios assess whether a company has sufficient short-term assets to meet its short-term liabilities. High liquidity indicates a lower likelihood of defaulting on short-term obligations.
Leverage Ratios evaluate the proportion of a company’s financing sourced from debt versus equity. A higher equity share often signals that shareholders have a greater stake in the business, providing a buffer to absorb losses before creditors are impacted.
Profitability Ratios measure a company’s ability to generate profit, which is typically a strong indicator of its capacity to repay debt and reinvest in growth opportunities.
Efficiency Ratios also known as activity ratios—analyze how effectively a company utilizes its assets and liabilities. These metrics offer insights into the organization’s operational performance.
At its core, financial ratio analysis is a fundamental component of the credit rating process, providing support for decision-making related to pricing, interest rates, payment terms, loan amounts, credit limits, collateral requirements, and alternative risk assessments.
The Benefits of Financial Ratio Analysis
Financial risk is an inherent aspect of all business activities. To manage this effectively, it is recommended your company establish clear thresholds for when to request financial statements. Once this threshold is met, it becomes the analyst's responsibility to assess potential financial risks and provide recommendations on whether to absorb, mitigate, or avoid these credit risks before finalizing any agreement.
Financial ratio analysis benefits:
Risk Adjusted Decision Making
You must ensure you are appropriately compensated for the credit risk being assumed. Analysts should evaluate not only the potential return but also the counterparty's credit rating. Riskier counterparties typically require higher returns to balance the risk-return ratio effectively.
Comparative Analysis:
Benchmarking financial ratios offers valuable insight into a counterparty’s competitive position and financial health within its industry.
Counterparties performing below industry averages pose heightened credit risks due to their vulnerability to market changes such as price fluctuations, shifts in supply and demand, or regulatory impacts. During economic downturns, underperforming companies often experience financial strain first, given their limited financial reserves, thin margins, and minimal liquidity
Trend Analysis and Forecasting:
Trend analysis involves examining historical data to identify patterns over time, particularly a counterparty’s past financial performance. Common forecasting methods included a 3 or 5 year average, linear forecasting, or using most recent fiscal year as a proxy for next year.
Key Ratios for Financial Statement Analysis
Calculating accurate financial ratios and interpreting the ratios are both required to make the right decision. Two common techniques for credit analysis are vertical and horizonal analysis.
How do you calculate vertical analysis?
Vertical analysis, also known as Common Size Analysis, is a method of line by line comparison of each financial statement line item as a percentage of another line items, such as revenue or total assets.
An example of vertical analysis is to calculate all expenses as a percentage of total revenue. Analysts can then assess the cost efficiency and determine whether the company's expense patterns align with industry norms. For the Balance Sheet, analysts typically examine each assets as a percentage of total assets, evaluating the asset structure and liquidity.
How do you calculate horizonal analysis?
Horizonal analysis, or trend analysis, compares the same financial statement line items over multiple periods. It provides a picture of growth patterns and cyclicality.
For example, by examining the trend in operating income over several years, we can discover whether the company's operating income is improving, deteriorating, or remaining constant.
8 Financial Ratios that Impact Creditworthiness
1. Interest Coverage Ratio
The interest coverage ratio measures the counterparty's agility to pay interest with its earnings before interest and taxes (EBIT). It measures the number of times a company could cover its interest expense with its operating profits.
Formula: EBIT / Interest Expense
EBIT: Located on the income statement. Also known as operating profit or operating income.
Interest Expense: Amount of interest that is obligated to be paid on its debt during a certain period.
2. Debt / EBITDA
Measures the amount of income generated from operations available to service debt obligations. The ratio can be interpreted as how many years it would take a company to pay back its debt if the company's debt and EBITDA ( Earnings Before Interest, Taxes, Depreciation, and Amortization) remain constant.
For example, a debt/EBITDA ratio of 3.5x could be viewed as it would take a company 3.5 years to pay back debt, assuming no additional debt was taken on nor EBITDA changed.
Formula: Total Debt / EBITDA
Total Debt includes both the short term (obligations due <12 months) and long term debt and is found on the company's balance sheet.
EBITDA is an indicators of a company's operating performance and profitability before non operating expenses.
3. Cash Flow From Operating / Debt
The cash flow from operations to debt ratio measures the company's agility to generate adequate cash from its operations to cover total debt.
Formula: Cash Flow From Operations / Total Debt
Cash Flow From Operations refers to the cash a company generates from its normal business operations and can be found on the cash flow statements. It starts with Net Income, adds back non-cash expenses, then adjusts for changes to working capital.
Total Debt includes both the short term (obligations due <12 months) and long term debt and is found on the company's balance sheet.
4. Debt to Equity
The debt to equity ratio gauges the balance between a company's total debt and its shareholders' equity (which is assets minus liabilities). This ratio offers insight into the financial leverage of the company, highlighting the relationship between funds borrowed from creditors and those from owners.
Formula: Total Debt / Shareholder Equity
Shareholder Equity represents the net value of a company, i.e., the amount that would be returned to shareholders if all the company's assets were sold and all its debts paid off.
5. Debt / Tangible Net Worth
The debt to tangible net worth ratio evaluates a company's debt in relation to its tangible value, which encompasses hard assets like plant, property, and equipment. This ratio reveals the extent to which the company is financed by borrowed funds and assets that creditors are unlikely to accept as collateral (like intangible assets).
Formula: Total Debt / (Shareholder Equity - Intangible Assets)
Total Debt includes both the short term (obligations due <12 months) and long term debt and is found on the company's balance sheet.
Tangible Net Worth is calculated by subtraction intangible assets, such as goodwill, trademarks, and copyrights, from the company's equity position.
6. Return on Equity (ROE)
Return on Equity is a measure of net income over shareholder equity. It illustrates how effective management is using a company's equity to generate a profit.
Formula: Net Income / Shareholder Equity
7. Operating Income Margin
Operating income margin, also known as operating profit margin, is a profitability ratio. It calculates the portion of a company's revenue remaining after covering production costs, excluding taxes and indirect costs like interest.
Formula: (Operating Income / Total Revenue) * 100
The operating income margin is determined by subtracting both the cost of goods sold (COGS) and operating expenses (like salaries, rent, utilities, and depreciation) from the total revenue. The line items are found on the company's income statement.
8. Net Profit Margin
Net profit margin measures the percentage of each dollar of revenue that results in a profit. The ratio helps businesses track financial health over time and compare with industry peers.
Formula: (Net Profit / Revenue) * 100
Net Profit: Also known as net income, is calculated by subtracting all expenses, including material costs, operating costs, interest expense, tax expense, from total revenue. This line item is found on the income statement.
One of the benefits of financial statement analysis is that it provides context. On their own, numbers might not reflect much. However, when compared to data from other time periods or industry standards, financial ratios offer insights into a company's performance, financial health, and competitive stance.
Final Thoughts
Financial statement analysis provides a standardized method for assessing a counterparties ability to repay debt obligations, expand operations, and withstand economic downturns. The analysis can also be used to determine if the counterparty is overperforming, underperforming, or on par with industry peers.
See how CreditKernel provides financial risk analysis to support your credit decisions.
Frequently Asked Questions (FAQs)
How do financial ratios impact credit ratings?
Financial ratios indicate a company's short term ability to pay its obligations, measure a company's total liabilities compared to equity, and demonstrate how efficiently a company can generate profit. Ratios at or above industry peers lead to lower probability of default.
What is vertical and horizontal analysis?
Vertical analysis looks at financial statement line items as a percentage of another line items, such as revenue or total assets. Horizontal analysis compared the same financial statement line items over multiple periods.