Financial Ratio Analysis
Calculating and examining customer financial ratios are methods used in customer financial analysis. Ratio analysis is a useful technique to measure, compare, and evaluate the financial condition and performance of a customer to identify and quantify risk. Ratios are useful to credit professionals because they relate or correlate different information from the customer's financial statements. Financial ratios help credit professionals to quickly evaluate a customer or applicant company's:
- Overall financial performance,
- Degree of financial leverage, and
- Return on equity and return on assets employed among other ratios measuring rates of return.
Ratio analysis usually involves computing a group of common ratios. Ratio analysis enables creditors to spot trends in a customer's financial performance, and to compare a customer's performance and financial condition with the average performance of similar businesses in the same industry. Ratio analysis is an excellent method for determining the overall financial condition of a customer's business. Ratios are also useful for making comparisons between a customer and other businesses in an industry.
Each of the following ratios is important in helping credit professionals to make informed decisions about whether to extend credit to customers, how much credit to extend, and what terms of sale are appropriate. A financial ratio is a simple mathematical comparison of two entries from a company's financial statements. There are literally hundreds if not thousands of ratios that could be calculated using information from a customer’s Balance Sheet, Income Statement and Cash Flow Statement. The key is for credit professionals to select ratios that they believe are indicative of  a customer’s ability to pay its debts as they come due and  the customer or applicant’s long term viability.
Balance sheet ratios measure liquidity and solvency (a business's ability to pay its bills as they come due) and leverage (the extent to which the business is dependent on creditors, and profitability). For example, Return on Equity is a profitability ratio. It measures the after tax return on equity capital. This ratio is an indication of management's performance. The value is computed by dividing net income available to common stockholders for the period by total equity as of the beginning of the period. Financial ratio analysis is used by credit professionals to answer these questions about customers:
- Is the business profitable?
- Can the business pay its bills on time?
- How is the business financed?
- How does the company financial performance this year compare to last year?
- How does the customer's performance compare with its competitors?
- How does the customer's performance compare to the industry norms?
Financial ratio analysis is a useful tool for determining a customer's overall financial condition. Industry-wide financial ratios are published by a variety of sources, including Dun & Bradstreet. Financial ratios are useful for making quick comparisons. Banks and trade creditors use financial ratio analysis to help them decide whether a business is a good credit risk or not. The good news is that you don’t need to understand the relevance of dozens of financial ratios. Calculating a handful of financial ratios can offer valuable insights about the creditworthiness or financial health of a customer or applicant.
See also 'Financial Ratios'
© 2012. Michael C. Dennis. All Rights Reserved. Michael is a business consultant with more than 10 years experience better manage risk.