Question

1. In the 5Cs method, the lender uses financial ratios such us Current Ratio, Inventory Turnover Ratio, Gross Profit–Sales Ratio and Interest Coverage Ratio to decide whether to accept a loan application of a firm or to reject it. Please explain the role of each ratio in shaping the lender decision.

• Current ratio:
• Inventory Turnover Ratio:

• Gross Profit–Sales Ratio:
• Interest Coverage Ratio:

Answer 1

The 5Cs is a methodology used historically for evaluation of loan capacity. The 5Cs are - Capacity, Character (or credit history in real sense), capital,colletaral & condition. Each form integeral to protect interests of lender. The given ratios help in evaluation of 5Cs as below -

Current ratio - It measure the liquidity of the operatiosn. Specifically it tests whether the current assets are enough to cover the current or immediate liabilities as and when they may arrive. A stress on this ratio may lead to liquidity crisis or "cash poor" situation wherein the company will be solvent but still unable to pay its immediate obiligations. This helps to evaluate Capacity & condition requirement viz a viz Capacity to repay the liability as and when the arise & conditions of financial repayment

Inventory Turnover - It is basically the ratio of stock to cost of goods sold (Formula is Avg Cost of goods sold divided by Average Stock). It defines how many times the inventory is churned during the year. Higher ratio indicates that there shows better cyclign of goods & thus lesser cash in WC. It is an excellent indicator of Condition

Gross profit-Sales Ratio - It shows the gross margin to sales before business operating expenses. Its pure margin on sales and helps to indicate how much is the profitability of the product and how much part of the revenue available for expenses.It is an a rough indicator of capacity viz a viz capacity to repay will be higher if margins is higher.

Interest coverage ratio - It indicates the number of times the EBIT covers the interest cost (formula is EBIT/ Interest) It shows whether the borrower has the capacity to bear the interest cost on its existing profits. A higher ratio acts as a cushion to lender on borrower's capacity to bear the interest cost. It is an indicator of capacity. It also is a passive indicator of credit history as the same wills how whether histroically the borrower has been able to sustain profits the bear the cost of loans.