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Credit Evaluation Overview

Ratios and Quality Indicators for Credit Analysis

This page provides business people several tools to help them formulate credit policies.  The following indicators are the same ones used by financial institutions in scoring loan applications.

Balance Sheet Qualty Indicators

Analysis of current non-cash assets (Days Receivable)

Definition: Average number of days customers take to pay.
Formula: Receivables x 360 (days in statement period)/Net Sales

When analyzing:

• Look for trends (Red flag: Customers paying slower)
• Compare Days Receivable with Terms Offered (Red Flag: Your terms are much less generous than what your customers are taking.)
• Compare Days Receivable with Industry Standards (Are you comparable to the rest of the industry?
• Obtain an Aging of Receivables (if there appears to be a collection problem).

Try Days Receivable worksheet (NEW WINDOW)

 

Days Inventory

Definition: Average days worth of inventory on hand
Formula: (Inventory x 360) / COGS (cost of goods sold)

When Analyzing:

• Look for trends
• Compare Days Inventory with Inventory Cycle
• Compare Days Inventory with Industry Standards

Try Days Inventory worksheet (NEW WINDOW)

 

Days Payable (D/P)

Definition: Average number of days business is taking to pay suppliers
Formula: Payables x 360
COGS

When Analyzing:

• Look for trends
• Compare Days Payable with Terms Offered by Suppliers
• Compare Days Payable with Industry Standards
• Obtain an Aging of Payables (if there appears to be a payment
  Problem)

 

Days Cash

Definition: The average days of cash a company has on hand.
Formula: Cash x 360
Sales

When Analyzing:

Rule of thumb is that three to seven days cash is adequate,
however, this varies significantly from company to company
and industry to industry.

 

Days Accrual

Definition: Average number of days business takes to pay wage-related expenses.
Formula: Accruals x 360/ COGS

When Analyzing:

• Look for trends
• Compare Days Accrual with Payroll Cycle

Try Days Accrual worksheet (NEW WINDOW)

 

Operating Cycle (OC)

Definition: Average number of days in which cash is tied up in operations of business before it returns as cash with a profit attached.
Formula: Days Receivable + Days Inventory - Days Payable - Days Accrual

When Analyzing:

• Is the company’s actual permanent working capital position near the level of the company’s needed permanent working capital
  position?
• Cash businesses (e.g. restaurants) can have a negative operating cycle and still be healthy.
• Long cycle businesses (ship builders, etc.) can have a very long operating cycle and still be healthy. They do, however, have a great need for additional working capital financing from outside the company.
• Red Flag: Beware of a company whose operating cycle goes from positive to negative.

Try Operating Cycle worksheet (NEW WINDOW)

 

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