Problem
As a user of accounting information, being able to compare financial information across time (for the same company) and across companies (at the same point in time) makes comparisons even more valuable. Common and easily understood ratios facilitate these comparisons.
A company's ability to repay a short-term loan is often a function of the company's liquidity. Liquidity is commonly measured by dividing a company's current assets by its current liabilities-this is called the current ratio. If a company already has a lot of debt, it might not be able to repay money it borrows. Leverage is a term used to measure how much debt a company already has and is commonly measured by dividing total liabilities by total assets. This is called a company's debt ratio.
You are a bank loan officer considering the loan application of a small business in your area. The small business is experiencing a seasonal cash crunch and has come to your bank for a short-term loan. You must assess the company's ability to repay the loan.
Respond to the following:
a) What questions would you want answered in considering the credit worthiness of this small business?
b) Why would a high current ratio indicate that the company is a good candidate for being able to repay a short-term loan?
c) Why would a low debt ratio indicate that the company is a good candidate for being able to repay a loan?
d) What existing debt ratio (between 0% and 100%) would make you nervous when considering loaning a small business even more money?