A bank employs ratios to check the pulse of your financial health. Ratios are used to identify the strengths and weaknesses of your business. These are the four major tools used when a bank is reviewing your loan application:
Profitability Ratio
It assesses a business's ability to generate earnings. Examples of profitability ratios are profit margin, return on assets and return on equity.
Profit Margin: Net profit, say $10,000 divided by sales, say $100,000 = 0.1 or 10%. It is useful to compare companies in the same industry and the higher the margin the better.
Return on Assets: How efficient a business is at using its assets to generate earnings. It measures the amount of profit made by a company per dollar of its assets.
The formula for return on assets is: Net Income/ Total Assets
Example: Net Income $100,000, Total Assets $500,000
100,000/500,000 = 0.2:1 or 20 cents per dollar
Return on Equity: It is a measurement of a company’s profitability. It calculates how many dollars of profit a company generates with each dollar of shareholders' equity.
The formula for return on equity is: Net Income/Shareholders' Equity
Example: Net Income $100,000, Shareholders’ Equity 1,000,000
100,000/1,000,000 = 0.1 or 10%
Liquidity Ratio:
It measures a company's ability to meet current obligations like paying for operating expenses. Insufficient fund to pay bills when it is due will impact the creditworthiness of a company. Too many liquid assets are also bad for the company because the fund is not effectively used to generate income. The liquidity ratios are the current ratio, quick ratio, and absolute liquid ratio.
Current ratio: It measures the ability of the business unit to meet the creditors’ demand. The ratio varies from industry to industry. It is generally around 1.5 and 3 for a healthy business.
The formula is: Current Assets/ Current Liabilities
Example: Current Assets $300,000, Current Liabilities 200,000
300,000/200,000= 1.5 or 1.5 to 1
For every dollar of current liabilities, there is a backing of $1.5 current assets
Quick ratio (acid test): It measures the ability of a company to use its cash or quick assets to retire its current liabilities immediately. A company with a Quick Ratio of less than 1 cannot currently pay back its current liabilities.
The formula: Cash and cash equivalent + marketable securities + Accounts receivable/ current liabilities
Example: Cash and cash equivalent + marketable securities + Accounts receivable = 250,000
Current liabilities = 2000,000
250,000/200,000 = 1.25 times
It shows that the company has quick assets of $1.25 for every dollar of current liabilities
Absolute Liquid Ratio: This ratio extends the logic further by taking out accounts receivable.
The formula is: (Cash + cash equivalent + marketable securities) / Current Liabilities (bank overdraft and creditors)
Leverage ratio
It looks at a company's ways of financing or measuring its ability to meet financial obligations. The best-known solvency ratio is the debt-to-equity ratio.
The formula is: Total Debt/Total Equity
Example: Total Debt = 600,000, Total Equity 1,000,000
600,000/1,000,000 = 0.6 to 1
It means for every dollar of a company’s equity the company owes creditors 60 cents
Activity ratio
It measures a firm's ability to convert different assets such as inventories and account receivables into sales and cash respectively. The asset turnover ratio and inventory turnover ratio are good examples of activity ratios.
Asset Turnover = Sales Revenue/Total Assets
This ratio measures the management’s effectiveness in using fixed assets. A higher turnover is preferred.
Inventory Turnover = Cost of Goods Sold/Average Inventory
Generally the quicker the inventory turnover the better it is. It indicates that stocks are sold and turned into cash quickly.
