Over time, financial ratios have been used to quickly evaluate the financial and operational health of a company. Ratios are precise, yet elaborate enough in their own way.
Most of these ratios can be calculated through financial statements and then compared with industry benchmarks to get a broader understanding. For bankers, the interpretation of the ratio is far more critical than the computation. Validation of solvency and performance are the two essential characteristics of such financial ratios.
Selection of critical ratios is essential for bankers to access asset management, capital management, liquidity, risk, and profitability.
To make it easier we have listed five key financial ratios required for commercial loan underwriting:
Profit Margin Ratio: This is a widely used profitability ratio, and it indicates the amount of profit generated over sales. This ratio measures the company’s ability to earn enough profit to sustain its business. Profit margins often vary from industry to industry, so, a prudent banker should always compare it with close competition and with the average industry standard.
Debt Ratio: This is a solvency ratio, which indicates the debt level of the borrower as a percentage of total assets. A lower debt ratio suggests more stable business and the higher is reverse. A ratio of 0.5 or less is considered as healthy, as this means the company has two times the assets as compared to liabilities. Anything more than 0.5 should be carefully examined before consideration.
Loan to Value (LTV) Ratio: This is a risk assessment coverage ratio that is very critical for mortgage underwriting. The LTV ratio ensures that the collateral is worth higher than the size of the loan. Higher the LTV ratio, more the risk involved.
Debt Service Coverage Ratio (DSCR): This is a liquidity ratio, which indicates the amount of cash generated by the business to service its debts (principal, interest, and leases). DSCR validates the borrower’s capacity to pay back the debt and keep running the business. DSCR between 1.25-1.5 is a relatively safe number to consider. However, it differs from business to business and depends on the risk aversion policies of the bank.
Net Worth to Loan Size Ratio: This ratio is used to compare the borrower’s net worth to the size of the requested loan. A high net worth indicates stable financial health, ultimately ensuring the repayment of the loan.
Ratio analysis is a proven technique to carry out quantitative analysis. However, financial ratios often vary across different industries and sectors, and comparisons between entirely different companies might not be advised.
So, it is advisable to examine industry peers through PEER COMPARISON to get more meaningful insights about the industry.
Use Probe42 to
- Access key ratios by downloading financial statements in an excel format
- Compare with peers in the same industry