Question

Which financial ratio is of the greatest concern to creditors

Answer 1

A financial ratio is the value of two selected numerical values taken from an enterprise statements. These ratios help in evaluating the overall financial conditions of an organisation or an enterprise.

Long term creditors would be interested in solvency ratio. Solvency ratio is defined as a company's ability to satisfy it's long term obligation. The three critical solvency ratios are:

1. Debt ratio

Debt ratio= Total liabilities/ total assets

Debt ratio is a financial ratio that indicates the percentage of company's assets that are provided via debt i.e ratio of total debt and total assets.

It shows company's assets which are financed through debt. If the ratio is less than 0.5, company assets are financed through equity. If ratio is more than 0.5 ,then company assets are financed through debt.

Higher debt ratio indicates greater risk with firm operations. It also implies low borrowing capacity which will lower firms financial flexibility.

2. Debt to equity ratio

Debt to equity ratio= short term debt+ long term debt+other fixed payment/ shareholders equity

A debt equity ratio indicates the relative proportion of shareholders equity and debt used to finance company's assets.

A good debit equity ratio is around 1-1.5. It depends on industry as some use more debt financing than others.

3. Times interest earned ratio

Times interest earned ratio= Earning before Interest and Tax / interest expense

Times interest earned ratio is a measure of a company's ability to honour it's debt payment. A higher ratio means that risk is less and company is in a better position in terms of solvency. Interest rate greater than 2.5 is an acceptable risk.