Introduction
This paper focuses on a bank providing long-term loans (10 years or more) as a company’s creditor. When banks assess a company’s financial health to determine the risk associated with a long-term loan, they are particularly interested in the firm’s ability to repay the loan, the stability of the company’s earnings, and the value of the company’s assets as potential collateral. Here are three financial ratios that are especially relevant to a bank when analyzing a company’s financial statements.
Debt-to-Equity Ratio (Leverage Ratio)
The debt-to-equity ratio measures a company’s financial leverage and indicates the relative proportion of equity and debt the company is using to finance its assets. It is calculated by dividing total liabilities by shareholders’ equity. A high debt-to-equity ratio implies that the company has been aggressive in financing its growth with debt, which can result in volatile earnings due to additional interest expense. For long-term creditors like banks, a lower ratio is preferred as it suggests a more conservative financing approach with less risk.
Warren, C., & Tayler, W. B. (2020) highlight the importance of understanding a company’s leverage, as it can impact the company’s risk profile and its ability to secure new financing.
Interest Coverage Ratio (Times Interest Earned)
This ratio measures a company’s ability to meet its interest obligations from its earnings. It is calculated by dividing earnings before interest and taxes (EBIT) by the interest expense. A higher interest coverage ratio indicates that the company can easily make interest payments on its debt, which is a positive sign for long-term creditors (Brigham & Ehrhardt, 2016). A low ratio could signal potential difficulties in meeting interest payments, which could lead to default.
According to Warren, C., & Tayler, W. B. (2020), the interest coverage ratio is crucial for creditors as it provides a direct indication of the firm’s short-term financial health and its ability to service its debt.
Cash Flow to Debt Ratio
This ratio assesses a company’s ability to repay its debt with its cash flow. It is calculated by dividing operating cash flow by total debt. It provides insight into the company’s financial flexibility and ability to generate enough cash to cover its debt obligations (Damodaran, 2012). A higher ratio means that the company is in a better position to cover its debts, making it more attractive to banks providing long-term loans.
The textbook by Warren, C., & Tayler, W. B. (2020) corroborates the importance of cash flow analysis, as companies must have sufficient cash flows to support their operations and debt repayments.
Conclusion
These financial ratios are essential tools for banks in determining the creditworthiness of a company seeking a long-term loan. By carefully analyzing these ratios, banks can make informed decisions about the level of risk they are willing to accept and the terms of the loan they are prepared to offer.
References
Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice.
Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset.
Warren, C., & Tayler, W. B. (2020). Financial and managerial accounting.