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CREDIT RISK MANAGEMENT

A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Ratio Analysis
There are three broad types of ratios that need to be looked at while analyzing a company. They are: Profitability Ratios Solvency & Leverage Ratios Liquidity Ratios

Lets look into each of these ratios in detail.

Profitability Ratios
These ratios will help an RM in analyzing the profitability of a company. Gross Margin - Gross profit (Excluding Depreciation and other income)/Operating income. Gross Margin shows the basic operating profit or the margin that the company makes by producing the goods without including any overhead costs. Operating Margin (EBITDA Margin) - EBIDTDA/Operating income. EBITDA margin is the most important ratio for the credit manager to track. The EBITDA margin represents the operating profitability of the company. EBIT/Total Income - EBIT shows the amount of profit available to service interest obligations. EBIT by total income reflects no profitability without including the financial costs (dividends and interest). Net Margin or PAT Margin - Earnings After Tax (EAT)/Total Income Net margins show the actual margin of the business after accounting for everything (all costs) including any exceptional income/expense. EBIT/Total Assets - This ratio is also called Basic Earning Power (BEP) of the business. It shows how much profit you generate by investing in assets. Sales/GFA or Fixed Assets Turnover - This ratio shows the amount of revenue you are able to generate by investing in Fixed Assets. This is important for companies that deploy a high amount of fixed assets to generate income. ROCE (Average Capital Employed) - (Interest expense+ EBT before exceptional)/average of (Total debt + tangible net worth + long term liability to be taken as quasi equity) for the previous year and current year This shows the returns from the business without interest costs on numerator and average capital employed as denominator. The average capital employed is the average of current and previous years capital (Total debt + net worth).

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CREDIT RISK MANAGEMENT


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM

Return on Equity (ROE) - Earnings after tax/capital and reserves This ratio gives the on the equity base of the company. The ratio can be misleading as if the company can take debt (as long as it is priced lower than ROCE) and increase the ROE by leveraging.

Solvency and Leverage Ratios


Solvency ratios indicate the long term solvency of the company and leverage ratios help in identifying how well a firm is using its borrowed money. Total Debt - Total Long term liabilities+ Long term debt due within one year+ Short term borrowings such as
commercial paper and working capital loan. This is simply the total debt of the company including both short term and long term. Contingent Liabilities These (contingent liabilities) are off-balance sheet items, but can have a material

impact on the company


Total Debt + Contingent Liabilities - This reflects the total external liability that can accrue on the

company outside its day to day working. Tangible Net Worth - Capital and reserves + Deferred tax liability - deferred tax asset- intangible assets - Revaluation reserve. TNW shows the net worth of the company after removing intangible assets and revaluation reserve from the company.
Total Debt/Tangible Net Worth - This is the most important leverage ratio for a bank. It shows the

leveraging of total debt of the company on the base of the tangible net worth.
(Total Debt+Contingent Liabilities)/Tangible Net Worth - This is a sort of worst case scenario for the

company and shows the leverage that might happen in the scenario that all contingent liabilities have to be borne by the company. Total Net Worth/Total Assets - This indicates level of solvency or the % of assets that will be actually liquidated for value on dissolution. Fixed Asset Cover Ratio - This shows the how many times the fixed assets cover the revenues. It implies if the company was to be liquidated how many years sales would you recover from FA. Interest Coverage Ratio - ((EBITDA + interest earned)/Interest expense) Interest cover shows the amount available to pay interest as a multiple of the interest expense. If this ratio is less than 1, no bank would sanction credit as the company does not have the capacity to service the loan. (EBIT+Interest Earned)/Interest Expenses - This is similar to interest coverage, but it takes into account depreciation also. In a long term analysis (>5 years) EBIT would be a better decision making

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

CREDIT RISK MANAGEMENT


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM tool to find then interest cover as the company will have to replace machinery and incur large fixed costs over time.

Liquidity Ratios
Liquidity ratios indicate a firm's ability to meet its short-term financial obligations. Net Cash Accrual/Total Debt - The net cash accrual computes the amount of cash that accrues to the company from its operations. The net cash accrual on debt ratio shows the amount of cash generated to repay the debt. Debt Service Coverage Ratio (DSCR) - (Net cash accrual + interest paid-25%((net working capitalcash and bank balance)-(net working capital previous year -cash and bank balance previous year)))/(interest paid+ long term debt due within one year in the previous year) A little long winded, but the DSCR is a critical ratio for the bank. This reflects the actual cash available post working capital needs of the bank. Current Ratio - Total current assets/Total current liabilities If there are sufficient current assets to service the current liabilities, the company is unlikely to face a liquidity crunch. It is more likely to pay on time. The higher the ratio, the better it is for a bank. Net Working Capital - Total current assets - Total current liabilities The net working capital available to the company is the difference between their current assets and current liabilities. This is the extra cash after servicing their trade liabilities. Net Working Capital/Net Sales - This gives you the amount of working capital required for every rupee of sales. So, if this ratio is 0.5, it would mean that for every 1 rupee of sales you require 50 paise of working capital.
Raw Materials Holding (in days) - (Closing balance Raw material + closing balance Consumable spares)*365/Raw material consumed

This shows how many days it takes from purchase of raw materials to conversion into WIP. WIP Holding (in days) - Stock in process*365/Cost of goods sold It tells us how many days does a company holds its WIP inventory before converting them into finished goods. FG Holding (in days) - Finished goods*365/cost of goods sold This shows the holding days for Finished Goods.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

CREDIT RISK MANAGEMENT


A QUALITY E-LEARNING PROGRAM BY WWW.LEARNWITHFLIP.COM Receivables Holding (in days) - Total debtors * 365/Total operating income This shows how many days of credit the company is giving for its trade receivables. Credit Availment/Days Payable (in days) - Creditors for purchases*365/(Purchases finished goods +raw material consumed) This shows how many days of credit the company gets from its trade suppliers. This ratio is also called Days Payable or Days Credit. Operating Cycle in Days - RM holding + WIP holding + Receivables holding + FG holding- Credit availment in days. The operating cycle reflects the total number of days the company would need to invest money in its working capital. This is a key requirement for calculation of working capital requirement as well as to keep track of efficiency in production process.

Finitiatives Learning India Pvt. Ltd. (FLIP), 2010. Proprietary content. Please do not misuse!

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