Tip of the Week: Financial Ratios That Can Help Make a Credit Decision, and a Surprise Ending

By Bob Shultz

There is much to consider when reviewing a company’s financials to determine its creditworthiness and set an appropriate credit limit: trends related to revenue, profit, and equity, for example. Examining the relationship between key financial factors enables you to penetrate the detail and better understand how a company is performing, and that is where ratio analysis comes in. 

The answers to the following question provide valuable insight into ratios you may find helpful when reviewing a company’s financials.

Question: What ratios derived from a customer’s financial statements are the most revealing of creditworthiness?
Several financial ratios can provide insights into a company’s creditworthiness by assessing its ability to meet its financial obligations. While different rations can be relevant depending on the industry and specific circumstances, the following ratios are generally considered important indicators of creditworthiness: 

• Debt to Equity Ratio: This ratio compares a company’s total debt to its shareholders’ equity, indicating the proportion of debt financing relative to equity financing. A lower debt-to-equity ratio suggests a lower financial risk and greater creditworthiness.
• Current Ratio: The current ratio measures a company's short-term liquidity by dividing its current assets (such as cash, receivables, and inventory) by its current liabilities (such
  as payables and short-term debt. A ratio above 1 indicates the company has sufficient current assets to cover its current liabilities, which is typically seen as a positive sign for creditworthiness.
• Interest Coverage Ratio: The interest coverage ratio assesses a company’s ability to meet its interest payments on outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense. A higher ratio indicates a greater capacity to cover interest obligations., which enhances creditworthiness.
• Debt Service Coverage Ratio: This ratio evaluates a company’s ability to service its long-term debt by comparing its operating income or EBITDA (earnings before interest, taxes, depreciation, and amortization) to its debt service obligations (principal and interest payments.)
• Operating Cash Flow Ratio: This ratio measures the cash flow generated from operations relative to the company’s total debt obligations. It indicates whether the company’s operating cash flow is sufficient to cover its debt payments. A higher operating cash flow ratio suggests a stronger ability to generate cash for debt repayment.
• Altman Z-Score: The Altman Z-Score is a formula that combines multiple financial ratios to assess the overall financial health and probability of bankruptcy of a company. It considers variables such as working capital, retained earnings, market value of equity, total assets, and total liabilities. A higher Z-Score implies a lower risk of default and higher creditworthiness.

Here’s the Surprise Ending. 
The above is an exact quote from ChatGBT. It only took a few seconds from the time the question was posted for the response. 

The question we need to answer is, “What effect will a resource such as ChatGBT, other Natural Language AI (Artificial Intelligence) processors, or other AI and ML (Machine Learning) tools have on credit professionals and credit department processes? Consider how these new tools and AI technology can help you and your staff. We are in a fast-changing technology-driven world. Understand what is out there, kick the tires, and let the creative juices flow. You can count on Credit Today to continue following the AI phenomena as well, and we will have more to share as solutions develop.