In this section, we examine the different ways in which creditors and owners look at a set of financial statements. Creditors are more balance sheet oriented. Owners and managers are more income statement oriented.
Short-term creditors are primarily interested in the balance sheet, which shows the firm’s current financial condition. These six ratios are commonly used for this purpose:
Lenders and creditors are concerned with two things: the borrower’s ability to repay and the security in case the borrower cannot repay.
Given these facts, how does a creditor view financial information? The answer depends upon whether we are dealing with short-term or long-term debt.
The importance of the income statement increases with the length of the loan. Bankers place more emphasis on liquidity for short-term loans. Note that the first six ratios are the same as for short-term credit. With long-term credit notice, now income statement ratios become more important.
As the duration of a loan increases, the importance of the income grows.
| Ratio | Primary measure |
| Debt/equity | Debt |
| Current ratio | Liquidity |
| Cash flow/current maturities of long-term debt | Debt |
| Fixed charge coverage | Debt |
| Net profit margin after tax | Profitability |
| Times interest earned | Debt |
| Net profit margin before tax | Profitability |
| Degree of financial leverage | Debt |
| Inventory turnover in days | Liquidity |
| Accounts receivable turnover in days | Liquidity |
For his Financial Statement Analysis: Using Accounting Information (2013), pp. 483–485), Dr. Charles Gibson of Stanford University conducted a survey of loan officers at large banks. Gibson asked bankers to rank over 50 ratios based upon their importance when examining loan applications. The ratios listed above were deemed to be the most important ones. The significance number was a relative ranking procedure. A high significance number means that the relative importance of a particular ratio is large across the sample of credit analysts in the study. Notice that liquidity and debt ratios are heavily emphasized.
In addition to the previous ratios, many bankers will require more detailed information about specific accounts.
Creditors generally place certain restrictions on borrowers. Quite often these restrictions are in the form of ratios. Gibson’s study points out the most common ratio restrictions.
| Ratio | Primary measure |
| Debt/equity | Debt |
| Current ratio | Liquidity |
| Dividend payout ratio | * |
| Cash flow/current maturities of long-term debt | Debt |
| Fixed charge coverage | Debt |
| Times interest earned | Debt |
| Degree of financial leverage | Debt |
| Equity/assets | Debt |
| Cash flow/total debt | Debt |
| Quick ratio | Liquidity |
| Ratio | Primary measure |
| Earnings per share | Profitability |
| Return on equity | Profitability |
| Net profit margin | Profitability |
| Debt/equity ratio | Debt |
| Net profit margin before tax | Profitability |
| Return on total invested capital after tax | Profitability |
| Return on assets after tax | Profitability |
| Dividend payout ratio | Other* |
| Price/earnings ratio | Other* |
| Current ratio | Liquidity |
Dr. Gibson also surveyed controllers of large corporations. He asked them to rank ratios based upon their importance to their company.
Managers are concerned with profitability first and liquidity and debt second. This contrasts with the view taken by creditors. Corporate controllers were asked to rank the usefulness of ratios.
| Ratio | Primary measure |
| Earnings per share | Profitability |
| Debt/equity ratio | Debt |
| Return on equity after tax | Profitability |
| Current ratio | Liquidity |
| Net profit margin after tax | Profitability |
| Dividend payout ratio | Other |
| Return on total invested capital after tax | Profitability |
| Net profit margin before tax | Profitability |
| Accounts receivable turnover in days | Liquidity |
| Return on assets after tax | Profitability |
After reviewing the information in this chapter, what are the primary differences in the ways that lenders view financial ratios versus others?
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