Impact of Financial Ratios on Credit Decision

Question: Discuss about the Impact of Financial Ratios on Credit Decision. Answer: Introduction The project report is about the impact of different kinds of financial ratios on the credit decision-making process of an organization. At the time of credit decision, it is important to evaluate the financial position both the lender and the applicant in order to avoid credit default. It is very important to take correct and effective credit decision for the smooth running of the business organization. On the other hand, decision-making process is an important as well as essential element of the management of any business organization (Moro et al., 2017). Hence, the project report is about the analysis and evaluation of all the necessary aspects of the impact of financial ratios on the credit decision-making process of a business organization. For the purpose of the report, secondary information has been collected from various sources and they have been evaluated in order to evaluate the effect of financial ratios on credit decision. The researcher of the report is a student of acco unting. Hence, the topic of the report is in the subject of the researcher. At the end of the report, a conclusion along with some recommendations is provided. Background and Definition of the Problem Taking the right credit decision is one of the most crucial aspects of any business organization. Credit decision helps the organizations to raises necessary funds for the smooth running of the businesses (Spronk, Steuer Zopounidis, 2016). For this reason, much necessary relevant information is needed. The financial statements of the organizations are the source of this information. For taking the credit decision for the organization, this information needs to be analysed and evaluated. This process discloses the true financial position of the organizations. The financial managers of the organizations need to check the various aspects of the financial health of the organization in order to evaluate the condition and performance of the business firms. In this regard, financial ratios are the important tools. Financial ratios help to evaluate the financial condition of the organization. This process helps the organizations in decision-making process. With the help of financial ratios, the financial managers of the organizations can reach to the effective conclusion about the financial health of the firms. Hence, the main purpose of the financial ratios is to help the financial managers of the organizations to communicate information from the various financial statements. Communication of financial statements helps in the process of credit decision making. It is evident that the business environment in twenty-first centuries has become more competitive as there are many companies in the world market. For this reason, it is important for the organizations to make effective business strategies in order to stay in the competition. Taking the appropriate financial decision is the backbone of financial strategies (Shepherd Rudd, 2014). The contribution of financial ratios is significant in this aspect. Hence, the study is determined to evaluate the various aspects of financial ratios on the decision-making process of the business organization. Aim of the Report The aim of the report is to evaluate and analyse the various aspects of financial ratios on the decision-making process of an organization. In this report, the major aim is to evaluate the impact of financial ratios on the credit decision-making process of an organization. The credit decision-making process is equally important for both the lender and the applicant. There are various purposes of taking credit from various banks and various financial institutions. Hence, it is the utmost responsibility of the credit organizations to evaluate the financial health of the credit applicants before providing them credit. This process can be done with the help of financial ratios. Financial ratios help to evaluate and analyse the financial information of the organization. Hence, it can be said that the main aim of the report is to analyse and evaluate the various aspects of financial ratios on the decision-making process. Objective of the Report There are many objectives of the report. The main objective of the study is to evaluate and analyse the impact of different kinds of financial ratios on the credit decision-making process of the business organizations. Another important objective of the report is to equip the researcher with the necessary knowledge to analyse and evaluate the financial statements of the organizations. This report assists the financial managers to understand the impact of various financial ratios on the decision making process. Another objective of the report is to make effective strategies for the organizations so that they can retain their place in the market. One of the most important objectives of this report is that it will help the researcher to obtain knowledge about accountancy as the project is all about finance and accountancy. These are the main objectives of the project that is based on the impact of financial ratios on the credit decision-making process. Literature review As discussed earlier, the major aim and objective of the report is to analyse and evaluate the importance of financial ratios on the credit decision of the business organizations. Hence, the report has taken an attempt to establish a relationship between financial ratios and credit decision-making process as financial ratios help to communicate the financial information among the financial managers of the organization (Graham, Harvey Puri, 2015). Hence, in this process, one just cannot ignore the significance of financial ratios in the credit decision-making process. At the time of providing credit to a business, the credit institutions need to know about the current financial health of the applicant organization. This process gives the credit giving organization an idea about the liquidity, profitability, debt position and more of the organization. Various important ratios help the organization in this process. Based on the result about the financial position of the organizations, the credit giving institutions provide credit to them. Thus, it is utmost important to discuss all the necessary ratios for the purpose of the report. After that, it is necessary to evaluate the impacts of those ratios on the credit decision of the organizations. Many ratios evaluate the financial position of an organization. The first ratio is the liquidity ratio. Liquidity refers to the financial power of an organization to meet its financial obligations. There are two types of liquidity ratios. They are short-term liquidity ration and long-term liquidity ration. The ability of the companies to pay the debts can be identified by evaluating these ratios (Baos-Caballero, Garca-Teruel Martnez-Solano, 2014). The next ratio is the Current Ratio. Current ratio can be written as current assets/current liabilities of an organization. Current ratio indicates the ability of the firm to pay the short-term obligations. It is better to have a higher current ration as low current ratio indicates the firms inability to pay the short-term debts (Kuzey, Uyar Delen, 2014). The next ratio is Quick Ratio. Quick assets can be written as quick assets-current liabilities. This ratio indicates the ability of the firm to pay all of its current liabilities if they come due immediately. This ratio is also called acid test ratio. In the acid test ratio or quick ratio, quick assets can be obtained by subtracting inventories from the current assets. It is better for the companies to calculate both current ratio and quick ratio as the calculation of only quick ratio would omit the inventories (Ogiela Ogiela, 2014). Another important financial ratio is Profitability Ratio. Profitability of a business refers to the ability of a firm to earn enough profit so that the liabilities and debts of that organization can be paid. The other name of profitability ratio is activity ratio as it indicates the ability of the firm to earn profit (Grant, 2016). The next ratio is Return on Sales. This is the percentage of net income to the net sales of an organization. This ration indicates the overall profitability of the organization. There are some divisions of return on sales ratio. They are Gross Profit Margin, Operating Income margin and Net Profit Margin (Tayeh, Al-Jarrah Tarhini, 2015). Gross Profit Margin refers to the profitability of the organizations based on the cost of goods sold. Gross profit margin can be written as Gross Profit/Sales*100. Gross profit margin shows the direct profit of the organization without indirect expenses (Delen, Kuzey Uyar, 2013). Another important financial ratio is Net P rofit Margin. Net profit margin can be calculated as Net Profit/sales*100. This ratio shows the ability of a firm to control the direct and indirect expenses of the organization. This process increases the ability of the organization to pay its liabilities and debts and helps to increase its credit rating (Heikal, Khaddafi Ummah, 2014). Another crucial financial ratio for credit decision is the Return on Assets ratio. This ratio is helpful to recognize the ability of the organizations to utilize its assets in order to make profits and paid dues. Higher percentage of return on assets ratio is desirable for the organizations as it indicates the higher portion of profit (Mathuva, 2015). The next financial ratio is Return on Operating Assets. This ratio indicates the ability of a firm to generate operating profit by using the assets of the organization. This ratio can be calculated as Net operating income/average operating assets (Dutt Humphery-Jenner, 2013). Another most important financial ratio is Return on Equity. Bu calculating this ration, financial managers can judge the ability of the organization to earn a return on the investment capital of the owners. Return on investment can be calculated as Net Income/Average Stockholders equity*100 (Friewald, Wagner Zechner, 2014). This is an important ration in order to take effective credit decision. The next financial ratio is Assets Management Ratio. This ratio indicates the ability of a firm to use all of its profits in order to get higher amount of profit. It is expected that the percentage of return on assets is higher so that the companies can earn more profits (Ang, 2014). Another important financial ratio is Inventory Turnover Ratio. This ratio helps to measure that how many times an organization sale its stocks or inventories in a given period. The formula for this ratio is cost of goods sold/average inventory (Agha, 2014). A higher percentage of inventory turnover ratios indicate that the inventory of the organization is sold on a good pace and there is a chance for high profitability. Another very important ratio is Debt Ratio. The main function of debt ratio is to establish a relation between total debt and equity of an organization. This ratio can be calculated by Total Liabilities/Total Assets*100 (Pescatori, Sandri, Simon, 2014). The next important ratio is the Equity Ratio or Proprietary Ratio. This ratio indicates that that how much of the firms capital is financed by the equity shareholders. The formula to calculate this ratio is Stockholders Equity/Total Assets*100. The higher percentage of this ration indicates that there is less chance o f solvency for the organization (Babalola Abiola, 2013). The next ratio is Debt-to-Equity Ratio. This is one of the most important ratios for credit decision. This ratio indicates the portion of debt and equity in the capital of the organization. This ratio is also known as Debt-Equity Ratio. The formula to calculate the debt to equity ratio is Total Debt/Total Equity. The companies having a higher debt to equity ratio is attractive to the creditors, investors, lenders and shareholders (Lewis Tan, 2016). The last financial ratio is Leverage Ratio or Gearing Ratio. This ratio measures the size of long-term liabilities. The optimal standard for this ration is 1:1. The companies having high portion of gearing ratio have to paid high amount of interest and this process may affect the profitability of the organization. This ratio can be calculated with the formula of Long-term Liabilities/stockholders Equity (Dessalegn et al., 2015). These are the main financial ratios that need to be taken into consideration at the time of credit decision. All these ratios are helpful tools to analyse and evaluate the financial health of an organization. In the process of credit decision, the financial situation of the organizations needs to be determined as the ability to repay all the debts depends on the financial ability of the organizations. Financial managers use these financial ratios to extract valuable information from the financial statements of the organizations so that this information can be communicated in the organization. Hence, it can be said that there is a lot of significance of financial ratios on the credit decision of the organizations. Methodology The main purpose of the research report is to analyse and evaluate the impact of key financial ratios in the process of credit decision. For the continuation of this study, a research process has been carried on. The process of carrying on the research process is called the methodology of the report. For the purpose of the report, one of the Australias largest retain conglomerate company Wesfarmers Limited has been taken into consideration (Wesfarmers.com.au, 2017). Secondary research process has been taken into consideration. The researcher has chosen a descriptive model of methodology for this research process. In this regard, the secondary data has been collected. The main source of secondary data was the latest annual report of Wesfarmers. Based on the financial information from the annual report of the company, four major ratios have been calculated that have a great effect on the credit decision. These ratios are Debt-to-equity ratio, Inventory turnover ratio, Net margin of the company and Quick ratio. These ratios have been chosen because credit-giving companies consider these ratios to judge the financial health of the applicant organizations. Hence, these ratios are the most important ratios that can affect the financial decision of any organization. Finding from Secondary Information Analysis As per the methodology of this research process, the researcher has adopted the secondary research method. All the secondary data has been collected from the latest financial report of Wesfarmers Limited. On the other hand, four major ratios have been taken into consideration; they are Debt-to-equity ratio, Inventory turnover ratio, Net margin of the company and Quick ratio. These major ratios have been given in the financial report of the company. These financial ratios assist the credit giving agencies in determining the financial position of the organization. Two years have been taken into consideration; that are 2015 and 2016. As per the financial report of the company, the debt to equity ratio for the year 2016 is 30.9% and for the year, 2015 was 25.1%. Inventory turnover ratios are 7.59 and 7.21 for the year 201166 and 2015 respectively. On the other hand, the latest financial report of Wesfarmers states that the net margin for the year 2016 and 2015 are 0.62 and 3.93 respectiv ely. Lastly, according to the latest financial report of the Wesfarmers Limited, the quick ratio of the company for the year 2016 and 2015 is -0.27 and -0.20. These are the findings from the secondary information analysis of the research (Wesfarmers.com.au, 2017). Discussion of Findings in Light of Literature Review It has been seen in the above discussion that the secondary data has been collected based on the latest financial report of Wesfarmers Limited. On the other hand, four major ratios have been taken into consideration. The result of these ratios is helpful to evaluate the financial position of the company that can affect the credit decision. As per the debt to equity ratio of the company, the debt to equity ratio in 2016 is 30.9 percent that is more than that of 25.1 percent in the year 2015. This ratio suggests that the total capital of the company is comprised of more debts than equity in the year 2016. This is not a desired situation as it is expected that debt to equity ratio is less for any company. A higher percentage of this ratios states that the company has to incur a lot of money for interest expenses and the company has already taken huge debts (Campbell, Galpin Johnson, 2016). The inventory turnover ratio for the year 2016 is 7.59 that are more than 7.21 in the year 2015. A higher inventory ratio suggests that the company has a good liquidity position. The stocks of the company have been sold on a fast pace that helps to generate cash for the organization (Lee, Zhou Hsu, 2015). The next ratio is the Net Margin ratio. The net margin ratio of Wesfarmers Limited for the year 2016 is 0.62 that is less than 3.93 for 2015. Higher proportion of net margin is expected for any organization as it explains the ability of the company to control its direct indirect expenses and helps the organization to register more profit. It has been seen that the net profit margin in 2016 has dropped drastically. The result of the ratio can negatively affect the credit decision of the company. The last ratio is quick ratio. It can be seen that the quick ratio of the company is in negative for the year 2016 and 2015 that is -0.27 and -0.20 respectively. This ratio states that the liquidity position of the company is very poor as the company has taken many debts and they do not have the capability to repay them. Hence, based on the above analysis, it can be said that the liquidity position of the company is not good, as the company has already taken many debts and bank overdrafts from the bank. Conclusion The study has taken an attempt to evaluate and analyse the effects of financial ratios on a companys credit decision. Based on key financial ratio analysis of Wesfarmers Limited, it can be said that the company has a poor liquidity position. The debt to equity ratio and quick ratio of the company is the proof of this fact. The debt to equity ratio states that the company has taken many debts for raising capital. On the other hand, the quick ratio suggests that the company currently do not have the liquidity position to meet its current obligation. Looking at this liquidity position of the company, the credit giving agencies and banks will not give any loan or debt to the company. Hence, for this reason, it is highly recommended that the Wesfarmers should take effective strategies to increase its liquidity position. It is also recommended that the company needs to emphasize on equity shares for raising capital. The decrease in taking debts will decrease the increase expenses of the or ganization. Thus, from the whole study it can be concluded that the financial ratios have great impact on the credit decision of an organization. References Agha, H. (2014). Impact of working capital management on profitability.European Scientific Journal, ESJ,10(1). Ang, A. (2014).Asset management: A systematic approach to factor investing. Oxford University Press. Babalola, Y. A., Abiola, F. R. (2013). Financial ratio analysis of firms: A tool for decision making.International journal of management sciences,1(4), 132-137. Baos-Caballero, S., Garca-Teruel, P. J., Martnez-Solano, P. (2014). 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