Financial Ratios Used by Lenders to Evaluate a Company

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Banks use credit scores to evaluate loan applications for individuals, but no such score exists for businesses. Lenders considering loans to a business use a variety of ratios calculated from the financial statements of the company seeking to borrow. These financial ratios can provide a lender with key information regarding the ability of a business to repay a loan.

Current ratio

  • One of the simplest ratios a lender may refer to is the current ratio. This is calculated by dividing current assets by current liabilities. This demonstrates a company's liquidity and its ability to pay short-term obligations using its current resources. Ideally, a lender is looking for this number to be greater than or equal to one because this will show that current assets are at least equal to current liabilities. This lets the lender know that all current obligations can be met.

Quick Ratio

  • The quick ratio (sometimes called the acid test) is a companion to the current ratio and a bit more restrictive. This ratio is derived by subtracting inventory from current assets and this total is divided by current liabilities. Inventory is not easily converted to full cash value quickly. A lending institution may want to compare the quick ratio to the current ratio if a significant amount of current assets are held as inventory. Again, the higher the number the better, but the minimum number should be greater than or equal to one.

Operating cash flow ratio

  • A company's net income can appear solid, but a lender needs to know how that income is generated. Net income can be comprised of receivables and occasionally manipulated by depreciation expense offsets. A lending institution will refer to a statement of cash flows to see how much cash is actually coming in and from what sources. The operating cash flow ratio takes into consideration a company's financial picture from the business side and eliminates money received from investing or financing activities. To calculate this ratio, the cash flow from operations is divided by current liabilities. This result will give a lender a truer picture of actual cash coverage available to a business.

Debt to equity ratio

  • Before a lender allows a business to take on more debt, the current debt to equity balance must be examined. Total debt divided by shareholder equity will provide a lender with a snapshot of how a company has been financing its growth. A high number may mean that a business will be unable to sustain such growth and may experience difficulties meeting its obligations. This number can vary greatly by individual company and the weight of this ratio is on a case-by-case basis.

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