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

1.

• The current ratio depicts the liquidity position of the company. It determines, how much current assets are available in a company to pay off the current liabilities as and when they becomes due. A high current ratio is above 2. This ratio helps to understand weather the business has enough liquidity to pay off the current liabilities.
• Inventory turnover ratio : This ratio depicts the ability of the company to convert the inventory into cash. This ratio depicts how many times a company has sold and replaced inventory over a given period. The higher the ratio, the better. This ratio depicts the level of efficiency of the business.
• Gross-profit sales ratio : This ratio measures the profitability of the business. The higher the ratio, the better. This ratio measures how much is left after paying off for the operating expenses. So, this gives the lender an idea , weather enough is left in the business to pay of the interest obligation of the debt, in case the company is able to raise debt.\
• Interest coverage ratio : This is the best indicator of the ability of the business to pay off interest obligation arising from the debt. The formula is : EBIT/ INTEREST . This ratio indicates how well the business can pay off interest expenses from the operating income. The higher this ratio, the better is the ability of the company to pay off debt obligations.