When one passes through difficult times, financial well-being is certainly a friend indeed. If one has positive scores on the parameters of financial well-being, then it is easier to obtain financial assistance in the form of loans from banks or financial institutions which would enable an individual to overcome the ill effects of downfalls.

Rule of conservatism

Every financial institution or bank wants to play the safer game. This implies that they want their customers to be profitable, capable of returning the loan amount (principal amount) along with the timely payment of interest besides offering collateral. In other words, banks or financial institutions want to see the customer passing the tests of profitability, liquidity and safety.

Test of profitability

An individual is said to be profitable when his/her return on equity is a positive figure. For instance, Anmol Anand earns R15,00,000 as total income in a year. His personal balance sheet shows R50,00,000 as his equity capital. His total expenses, including interest on loans, personal income tax expense and all other expenses, come to R10,00,000 in the same year. So, Anmol earns a post-tax return of R5,00,000 on the owners? equity of R50,00,000, i.e 10%.

The calculation presented above shows that Anand is profitable but it does not answer the question of whether he is the most preferred customer to lend. The lender can capture the income tax expense from the tax return filed by the customer but may fail to get the details on his other expenses and hence rely on the risk of the self-declaration by the customer, which is very dangerous.

Test of liquidity

The result of the profitability compels the lending institution to go for the second test in order to arrive at a credit score for the customer. The term liquidity refers to the ability of a customer to meet his short-term financial obligations in time. Here, short-term financial obligations refer to obligations that need to be met within a period of one year. Current ratio is the conventional measure used by lenders to assess the liquidity position of a customer. Current ratio is said to be favourable for a customer who has current assets that is theoretically at least twice that of his current obligations/liabilities. But in reality, the number may vary according to the individual?s exposure to risk and the economic conditions prevailing at the time of sanctioning loans. But a higher current ratio need not be an all-time favourable indicator as poor quality of current assets may spoil the realisation of proceeds from the sale of current assets.

Since current ratio is not assessing the liquidity of a customer in a convincing manner, lending institutions may opt to do the quick ratio or cash ratio computations to draw meaningful inferences about the customer?s liquidity position. Both quick and cash ratios have current liabilities as the denominator but ?quick or monetary assets? is the numerator for quick ratio and ?cash assets? is the numerator for cash ratio.

Quick assets are arrived at after subtracting the amount of inventory and prepaid expenses. Cash assets are the sum of cash in hand, cash at bank and marketable securities, which can be converted into cash within a period of 90 days. Among these variants, cash ratio measures the liquidity of an individual in a relatively better manner.

Lending institutions can alternatively compute a day?s cash ratio of the borrower before sanctioning the loan. For instance, Anmol has cash and equivalent of R300,000 as per the data presented by his personal balance sheet, and has reported an annual operating expenses of R720,000 (i.e daily expense of R2,000 thereby day?s cash of 150 days ? R3,00,000 divided by R2,000. This clearly indicates that the individual is in a superior position to meet his cash requirements.

Test of safety

This is perhaps the final test which needs to be done by the financial institution to take a concluding call on whether to lend money to the applicant or not. An individual may be profitable and liquid enough but need not be safe to lend. Safety can be measured by computing the solvency ratio. Here, solvency refers to the ability of an individual to meet all his long-term obligations/liabilities in time. Long-term liabilities are those that need to be repaid over a longer period of time, normally exceeding one year. Debt to equity ratio is the most used metric to measure the solvency position of a firm/individual. Lower the D/E multiple, better is the ability of the individual to take further/additional borrowings.

Banks can also compute the fixed charges coverage ratio to assess the safety of a customer. Fixed charges cover is computed by dividing the earnings before interest and fixed charges by the fixed charges. For instance, Anand has R600,000 as earnings before interest and fixed charges and R150,000 as fixed charges, then his fixed charges cover would be four times. Higher the fixed charges cover, better is the solvency of the individual.

The author teaches accounting and finance courses at IIM Ranchi