Question

Identify and describe the five most important ratios for a potential bank investment in a short-term corporate loan. Explain the reasoning for your selection. Illustrate your discussion using numerical examples.

Answer 1

Five most important ratios for a potential bank investment in a short term corporate loan are as follows:-

1. Current Ratio :- This ratio's usage is for measuring the company's short term position of liquidity. It is calculated by dividing current asset by current liability. An ideal current ratio is considered to be 2:1. Any company having this ratio as its current ratio is considered to be financially sound for its short term liquidity poition. It is used to determine how effeciently a company is able to pay off its current liabilities. If the Current Asset is equal to Current Liability, then it would mean that the current assets are just about good to pay off the liabilities. However, if the Current Assets is less than Current Liability then it is not considered to be good because this would mean that the comapany does not have assets to repay off its current liability. This is a negative indicator towards the functioning of the company. The following are to be considered when considering the Current Assets and Current Liabilities: -

Current Asstes	Current Liability
Investments	Deffered Revenue
Accounts receivable maturing within 1 year	Accounts Payable
Other Recievables	Other Accrued Expenses
Inventory (Raw Material, Finished Goods, WIP)	Accrued Compensation
Office Supplies	Accrued Income Taxes
Prepaid Expenses	Short Term Notes
Advance Payments

If a company is having Current Assets amounting to a total of Rs 1000 lacs and a Current Liability amounting to a total of Rs 750 lacs therefore, the current Ratio as per the above formula will be 1000lacs:750lacs i.e., 1.33. This means that the comapny has a current asset which is 1.33 times greater than current liability.

2. Quick Ratio/Acid Test Ratio :- Quick Ratio or Acid Test Ratio is used for measuring liquidity of a company by using more liquid type of current assets. We compute the quick ratio in just the same manner as the Current Ratio is calculated. The only difference is that we remove the inventories and prepayments from the current assets. Quick ratio is computed by dividing the Quick Assets by Current Liabilities. An ideal Quick ratio is considered to be 1:1. Quick assets are the ones which are easy to get converted into cash. A quick ratio of more than 1 means that the company's quick assets are sufficient to pay off the current liabilities. Example, If the quick asset is Rs 100,000 and the Current Liability is Rs 80,000 , therefore as per the above formula the quick ratio will be 100,000/80,000 thereby giving us 1.25. This mean that the comapny is having a positive acid test ratio and it is financially sound to meet its short tem obligations because the liquid assets are more than the current liabilities.

3. Debt Equity Ratio :- This ratio is used by the company so as to evaluate its financial leverage. This ratio holds great importance in corporate finance. It basically states the amount of debt component the company is employing in its business in comaprison to its owned fund. Higher the debt-equity ratio, bad is the position of the comapny. It is not wise to have a debt more that equity. This is computed by dividing the debt by equity. Debt includes Long term Loans, Debentures and other borrowings from banks. Equity on the other hand will include Equity SHare Capital, Preferance Share Capital and Reserves and Surplus (excluding losses). Example, if debt is Rs 100lacs and Equity is Rs 50lacs, then the Debt Equity Ratio will be 100/50 i.e., 2:1. This means that the company has twice the amount of debt as comapred to its owned fund. This means that the company is financially levered.

4. Debt Service Coverage Ratio :- This is used in order to measure the cashfows so as to payoff the current debt obligations. This ratio has a usage of analysing the firms, projects, etc. The formula for computing DSCR is

Net Operating Income/Total Debt Service.  

where, Net Operating Income = Revenue - Certail Operating Expense(COE)

Total Debt Service = Curent obligations of debt

If a DSCR is less than 1 then it would mean that the company has a negative cashflow. This would imply that the borrower will not be able to pay its debts due to the negative cashflow. If the DCSR is 0.8, it would mean that the company has only that much Net Operating Income so as to cover 80% of its annual debt payment. Therefore, higher the DCSR, the better it is for the company.

5. Debt Ratio :- Another ratio which is used by the comapny to emasure its financial leverage. It is the ratio of total Debt to Total Asset and is expressed in percentage terms. If the ratio is more than 1, then it would mean that a major portion of the debt is funded by assets. This means that the company has more debts in comaprison to its assets. Higher the ratio, the bad it is for the comapny and vice versa. It is calculated as follows:-

Total Debts/Total Assets

Greater debt ratio means that the company is highly levered, thereby increasing the risk of the comapny along with its fixed interest oayment obligations. Therefore, a greater debt ratio is considered to be bad for a company. On the contrary, if the ratio is less than 1 then it would mean that the company is not very much financially levered. Hence teh risk also gets reduced. An ideal company will be one which has a lower debt equity ratio, likely to be less than 1. Example, The total Debt of a company is Rs 2500 lacs and its total assets is Rs 2000 Lacs. Therefore, the debt ratio will be Rs 2500/Rs 2000 giving us 1.25. This means that the company is financially levered and hence is not to be considered to be ideal as its risk is very much. Its debt is 1.25 times greater than its total assets. Hence, it is not considered that the comapny is following a sound business structure.