Page 21 - Banking Finance October 2023

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Debt Management: Debt ratios, like the debt-to-equity stringent measure of liquidity that excludes inventory from
ratio and interest coverage ratio, offer insights into a current assets. It focuses on assets that can be quickly
borrower's leverage and debt repayment capacity. Lenders converted into cash to cover short-term liabilities.
analyze these ratios to ensure that the borrower has a Quick Ratio = (Current Assets - Inventory) / Current Liabilities
manageable level of debt and can meet interest payments.
This ratio provides a clearer picture of a company's
Trend Analysis: Ratio analysis enables lenders to track the
immediate ability to meet its obligations without relying on
financial performance of the borrower over time. By inventory sales.
comparing ratios from different periods, lenders can identify
positive or negative trends that might affect the borrower's Cash Ratio: The cash ratio is the most conservative liquidity
ability to repay the loan.
ratio. It measures the company's ability to cover short-term
liabilities using only its cash and cash equivalents.
Comparative Analysis: Ratios allow lenders to compare the
borrower's financial performance with industry benchmarks Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
and similar businesses. This helps lenders understand how
the borrower stacks up against competitors and whether This ratio gives insight into the company's extreme short-
they are operating in line with industry norms. term liquidity position.

Customized Evaluation: Different types of loans have These liquidity ratios help lenders, investors, and analysts
different requirements and risk profiles. Ratio analysis evaluate a company's ability to handle short-term financial
enables lenders to tailor their assessment based on the challenges, pay its creditors, and maintain smooth
specific characteristics of the loan and the borrower's operations. High liquidity ratios indicate that a company has
circumstances. a strong ability to meet its immediate obligations, while low
ratios could suggest potential liquidity issues.
Now we will learn and understand different kind of ratios
used in loan assessment and it's application. It's important to note that the ideal liquidity ratios can vary
by industry and business type. For instance, industries with
Liquidity Ratios: rapid inventory turnover might have lower current ratios
due to their efficient use of resources. On the other hand,
Liquidity ratios are a set of financial ratios that assess a industries with longer sales cycles might require higher
company's ability to meet its short-term financial obligations liquidity ratios to cover extended periods without generating
and manage its immediate cash flow needs. These ratios cash.
provide insights into the company's liquidity position, which
is crucial for maintaining operational stability and meeting
When assessing a loan application, lenders often use liquidity
short-term debt obligations. Here are some important ratios to ensure that the borrower has enough liquidity to
liquidity ratios:
Current Ratio: The current ratio measures the company's
ability to cover its short-term liabilities with its short-term
assets. It is calculated by dividing current assets by current
liabilities.
Current Ratio = Current Assets / Current Liabilities

A higher current ratio indicates better short-term liquidity,
as the company has more assets available to cover its
current obligations. However, an excessively high current
ratio might suggest that the company is not efficiently
utilizing its assets.

Quick Ratio (Acid-Test Ratio): The quick ratio is a more

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