ASSET/LIABILITY RATIO WHEN EVALUATING CREDIT WORTHINESS
The Asset/Liability Ratio can be a useful quick tool in evaluating credit. Typically, principals of a company always overstate net worth and owner’s equity. From a credit granting perspective these factors should not be weighed heavily in the credit granting process. Rather, emphasis should be placed on the “Current Asset/Current Liability Ratio.” Granting credit is “short term” whereas net worth and equity has accrued over the “long term” and both are typically inflated.
In working with credit granting professionals over the years, Williams & Williams has come to the conclusion that a favorite analytical tool is the “Current Asset/Current Liability Ratio.” This ratio provides a clue as to the debtor’s immediate borrowing ability and also tells a story about current cash flow. It is important to know whether or not over the years if Current Assets are increasing over Current Liabilities. Ideally, the “Current Asset/Current Liability Ratio” should be at least 2/1 or greater. If it is less, then additional credit investigation is warranted. Many credit grantors require personal guaranties if this ratio is lower than 2/1. When it is 1/1 or worse, many times credit is denied unless additional investigation about cash flow reinforces the ability to pay in the short term. Also, if a credit officer were thinking “outside of the box,” should the “Current Asset/Liability Ratio” be less than 2/1, then requesting a current Balance Sheet, Operating and Financial Statements would be prudent.
In the peaks and valleys of day-to-day business it is important that the credit grantor know that a debtor has the ability to borrow funds. Lending institutions, no matter what equity position is stated, look unencumbered assets (current assets) and the other essential ingredient is “payback ability,” which, of course, is cash flow. Over the period of a calendar year, cash flow must be positive and be sufficient to show this payback capability or a loan will be denied. Thus, a bank would be more than happy to provide a loan if during a year’s time there is sufficient positive cash flow to service a debtor’s obligation to a bank.
In evaluating credit, remember one of the most important tools is the “Current Asset/Current Liability Ratio.” It is one of the best analytical tools that a credit grantor can have in his or her repertoire.