Question

Bank executives consider liquidity and debt ratios to be most important when evaluating a loan applicant. What ratios are they referring to, and why would these be so important in bank-credit and trade credit decisions?

Answer 1

Answer:-

Liquidity Ratio: Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. It is commonly used by creditors and lenders when deciding whether to extend credit to a business. It is a result of dividing cash and other liquid assets by the short term borrowings and current liabilities. The higher the liquidity ratios, the higher the margin of safety that any company posses to meet its current liabilities.

Debt Ratio: Debt ratios focus on a firm's ability to pay its short-term debt obligations.It measures the ability of a company to repay principal amount of its debts, pay interest on its borrowings, and to meet its other financial obligations. It also give insights into the mix of equity and debt used by a company. It shows hpw much a comoany relies on debt to finance assets. It is also used to measure the extent to which an organization uses debt to fund its operation.

These ratios are important in bank-credit and trade-credit decisions because of the reason that equity investments in a business could be put at risk if the debt level is too high. They determine the extent to which loaned funds could be at risk. Thay help in revealing the existence of any issues where the debt load of an entity is increasing over time, or where its ability to repay debt is declining. Liquidity ratios are used by the creditors and lenders to decide whether to extend credit or debt. If the ratio is high,it states that the ability of firm to pay off its obligations in a timely manner is better. Hence while evaluating a loan applicant, bank executives consider these two ratios to be the most important because the surity of getting back the loaned amount with interest thereon could only be evaluated by these ratios only as they determine the financial stability and worthiness of a company and the borrower's ability to pay off its current debts by generating and managing cash. Whether the company is in a position to pay back the liabilities is detemined by liqudity and debt ratios only. A solid understanding of ratios can help any commercial lender become more successful.