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Key financial ratios for the credit department.(SELECTED TOPIC)
Financial ratio analysis is an excellent method for determining the overall financial condition of a customer's business. Financial ratios are also useful for making comparisons between a customer and other businesses in an industry.
Remember that a financial ratio is a simple mathematical comparison of two entries from a company's financial statements. There are thousands of ratios that could be calculated using information from a customer's Balance Sheet, Income Statement and Cash Flow Statement. The key is for credit professionals to select ratios that they believe are indicative of (1) a customer's ability to pay its debts as they come due and (2) the customer or applicant's long-term viability.
Credit professionals can use the following financial ratios to chart trends in a customer's financial performance, and point to potential problem areas that require additional scrutiny by the credit manager. Each is important in helping credit professionals make informed decisions about whether to extend credit to customers, how much credit to extend, and what terms of sale are appropriate.
Liquidity Ratios
These ratios indicate the ease of turning current assets into cash. Liquidity refers to a company's ability to meet current obligations with assets that can be quickly converted to cash. Liquidity ratios give an indication of a company's ability to retire short-term debts as they come due, and include the Current ratio, and the Quick ratio.
* The Current ratio formula is current assets divided by current liabilities. It is one of the best-known measures of financial liquidity and is the standard measure of any business' financial health. It will also give an idea about whether a customer is able to meet its current obligations by measuring if it has enough assets to cover its liabilities.
* The Quick ratio formula is current assets (less inventories) divided by current liabilities. The Quick ratio is a more rigorous measure of liquidity because it excludes inventories when evaluating current assets.
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