A business can report a profit and still struggle to pay suppliers. It can also hold substantial assets that are difficult to convert into cash. Financial ratios help a commercial credit analyst investigate these differences, provided the calculations are interpreted together and in context.
No ratio supplies a universal approval threshold. A useful analysis connects the figures to the customer’s industry, operating cycle, statement quality, and actual payment behavior.
Check the statements before calculating
Confirm the legal entity, consolidated or standalone scope, reporting dates, currency, and units. Identify whether information is audited, reviewed, compiled, or prepared internally, and examine qualifications where applicable.
Compare like periods and investigate restatements or classification changes. An annual income statement and a three-month interim statement cannot be compared as if they cover the same activity.
The SEC’s financial statement guide explains why the balance sheet, income statement, and cash flow statement provide different perspectives. A credit review benefits from reading them together.
Liquidity: what supports near-term payment capacity?
Current ratio = current assets ÷ current liabilities. If a customer has $1.8 million in current assets and $1.2 million in current liabilities, its current ratio is 1.5.
Investigate the assets behind that result. Slow-moving inventory and overdue customer receivables may not provide cash when obligations fall due.
One definition of the quick ratio is cash, cash equivalents, short-term marketable investments, and net trade receivables, divided by current liabilities. State the components used because definitions vary. Excluding inventory offers a different perspective, but receivable quality still matters.
Leverage: how much financial pressure already exists?
Total liabilities to equity = total liabilities ÷ shareholders’ equity. This broad measure compares recorded obligations with the equity base. It differs from a debt-to-equity measure that includes only specified interest-bearing debt.
Define debt clearly and apply the definition consistently. Negative or very small equity can make a ratio difficult to interpret; do not present the resulting number as an ordinary comparison.
Read relevant notes for commitments, maturity dates, guarantees, and other obligations. A single balance-sheet ratio cannot explain the timing or terms of every claim on cash.
Coverage: can operating earnings support financing costs?
Interest coverage = earnings before interest and tax ÷ interest expense. EBIT of $300,000 and interest expense of $100,000 produces coverage of 3.0 times.
Check whether the period and expense definitions match. An unusual gain may inflate earnings without improving recurring payment capacity. A zero denominator makes the ratio undefined rather than infinitely reassuring.
If you use EBITDA-based or debt-service measures, document their components separately. EBITDA is not cash available to suppliers; it does not capture every cash requirement.
Profitability: is the trading model sustainable?
Operating margin = operating profit ÷ revenue × 100. Compare trends and investigate major changes in pricing, costs, and business mix.
Stable profitability may support the assessment, but the statement’s revenue recognition and unusual items still require attention. A profitable sale made on extended terms may increase receivables without producing an immediate receipt.
Cash conversion: where is cash tied up?
A common cash conversion cycle is days inventory outstanding + days sales outstanding − days payable outstanding. For an operating analysis, inventory days can use average inventory divided by cost of goods sold, multiplied by period days. Receivable days can use average trade receivables divided by credit sales, multiplied by period days.
Payable days ideally uses average trade payables divided by credit purchases, multiplied by period days. If cost of goods sold is used as a proxy, disclose that choice and its limitations. Match the balances, transactions, and period consistently.
A longer cycle can indicate more funding tied up in operations, but the reason matters. A planned seasonal inventory build differs from obsolete stock accumulating unexpectedly.
A hypothetical example: profit without available cash
Assume a customer reports $200,000 in net income. Its receivables increase by $250,000, inventory increases by $150,000, and payables increase by $100,000. Ignoring all other adjustments, the simplified operating cash bridge is $200,000 − $250,000 − $150,000 + $100,000, or negative $100,000.
This illustration is not a complete cash flow statement. It shows why reported profit and operating cash generation can diverge. The analyst should investigate the actual statement and supporting notes before drawing a conclusion.
Turn ratios into a documented assessment
- Compare multiple periods and relevant operating conditions.
- Define every formula and data source.
- Investigate unusual movements and weak asset quality.
- Connect financial findings with payment behavior and exposure.
- Document uncertainty and avoid mechanical approval thresholds.
CMS Credit Suite supports financial analysis, period comparisons, and user-defined ratio calculations and scoring.
Contact Credit & Management Systems, Inc. to discuss organizing financial analysis within your commercial credit workflow.