Essay Example on Four Financial Ratios Used by Credit Rating Agencies

Introduction

Credit rating agencies such as Standard and Poor's as well as Moody's, utilize both qualitative and quantitative credit analysis techniques to determine if individual firms are capable of fulfilling their financial obligations. In their quantitative analysis, the agencies use several ratios to determine the financial capabilities of particular firms. They majorly use four categories of ratios, which include profitability ratios, leverage ratios, liquidity ratios, and coverage ratios (Kisgen, 2019). Proper understanding and interpretation of financial ratios is critical in determining the ability of a firm to generate earning and its general performance relative to its competitors.

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Profitability Ratios

Profitability ratios generally indicate the ability of a firm to make profits from its operations. Credit rating agencies use several profitability ratios to help lenders determine the rate at which individual firms and corporations grow and their ability to pay back loans. The ratios include margin ratios and return ratios. Margin ratios are used to determine the margin at which firms and corporations achieve their set objectives and goals; they include operating profit margin, gross profit margin, and earnings before tax, depreciation, interest, and amortization (EBITDA) (Jiang & Packer, 2019). Operating profit margin helps in determining the percentage profit an individual firm generates from its operations before deducting taxes and interest. It is obtained by dividing the operating profit by the total revenue. Other essential ratios consist of Return on Asset (ROA) risk-adjustment return and Return on Equity (ROE) (Jiang & Packer, 2019).

Leverage Ratios

Credit rating agencies use leverage ratios in comparing the level of individual firm's debt against its balance sheet, income statement, and cash flow statement. These ratios include debt to capital ratio, an asset to equity ratio, debt to equity ratio, and debt to asset ratio (Kisgen, 2019). A relatively low leverage ratio indicates high liquidity of an organization's assets, thereby signaling less existing risk. The debt to equity ratio helps in determining the value of total debts and financial liabilities against shareholders'' equity. Debt to asset ratio helps in determining the level at which an organization's operations are funded by debt. Stock market analysts are always interested in these ratios as they reflect the capital structure of an organization as well as the financial solvency of these individual organizations.

Liquidity Ratios

Liquidity ratios indicate the ability of an organization to convert its assets into cash. Credit rating agencies utilize these ratios to determine a borrower's ability to meet their current debt obligations. They include the current ratio, quick ratio. The current ratio determines an organization's ability to meet its short-term financial obligations that are due within one year (Jiang & Packer, 2019). Quick ratio helps in determining an organization's ability to meet its short term liability obligations through the use of assets that can be readily converted into cash.

Coverage Ratios

Coverage ratios always determine the coverage that cash, assets, or income provides for interest or debt expenses. They include interest coverage ratio and debt-service coverage ratio (Kisgen, 2019). The debt-service coverage ratio measures an organization's ability to use its operating income to meet all its short-term and long-term liability obligations, which include meeting both the principal and interest of these liabilities. On the other hand, interest covering ration helps in measuring an organization's ability to pay interest on its outstanding debts.

Decomposition of ROE

Return on equity is the measure of an organization's annual return against shareholders' equity, always expressed as a percentage. It always evaluates the profit obtained from each dollar from shareholders' equity. ROE brings together the balance sheet and the income statement, which makes it a two-part ratio when considering its derivation. It always reflects an organization's ability to turn assets into capital (Hossain, Salam, & Sen, 2019). It is obtained by dividing net income by shareholders' equity.

There are some drawbacks attributed to ROE; one such is that it does not include intangible assets such as goodwill, copyright, and trademarks. For this reason, it can be misleading if compared with other organizations that choose to include these intangible assets in their calculations. Additionally, it can be skewed by share buyback as this will reduce the number of outstanding shares. As a result, the ROE ratio will increase due to the decrease in shareholders' equity (Hossain et al., 2019).

The Difference in Approach of International Financial Reporting Standards and US GAAP Accounting

International Financial Reporting Standard (IFRS) is a set of accounting standards which are recognized internationally and govern how different types of business transaction are to be reported in the financial statement. On the other hand, US Generally Accepted Accounting Principles (GAAP) is a set of accounting standards that govern how businesses within the United States are to report different financial transactions in their financial statement. These two accounting standards differ in their approach as IFRS is principle-based while GAAP is rule-based (Turlington, Fafatas, & Oliver, 2019). Though both these two accounting standards recognize first-in, first-out method (FIFO) and weighted average-cost method, IFRS does not recognize the last-in-first-out method (LIFO).

IFRS enhances the comparability of different organizations' financial statements in the global financial arena, thereby helping in fostering accuracy in terms of competitive advantage strategies. It also helps in instant recognition of loss, thereby helping stakeholders in making better decisions. The major disadvantage of IFRS is the bottlenecks experienced by international accounting standard board (IASB) in enforcing these standards across different countries all over the world. On the other hand, GAAP utilizes a rule-based approach that lists the rules that organizations must abide by in preparing financial statements. However, GAAP's approach directs organizations to prepare financial statements that are present truthful and accurate data to creditors rather than shareholders (Turlington et al., 2019).

Conclusion

Financial ratios are absolutely necessary for analyzing a firm's financial position, liquidity, solvency, profitability, and effectiveness of operations. Effective understanding and interpretation of financial ratios are critical, both internal and external stakeholders in making financial and investment decisions. In their efforts to ensure effective financial analysis, organizations need to pay close attention to both principle-based and rule-based accounting standards as a way of ensuring accuracy, consistency, and accountability. IFRS and GAAP are equally essential for attaining accounting efficiency and effectiveness.

References

Kisgen, D. J. (2019). The impact of credit ratings on corporate behavior: Evidence from Moody's adjustments. Journal of Corporate Finance, 58, 567-582. doi:10.1016/j.jcorpfin.2019.07.002

Jiang, X., & Packer, F. (2019). Credit ratings of Chinese firms by domestic and global agencies: Assessing the determinants and impact. Journal of Banking & Finance, 105, 178-193. doi:10.1016/j.jbankfin.2019.05.011

Hossain, M. K., Salam, M. A., & Sen, T. (2019). Measurement of the financial performance of a commercial bank from varied perspectives: A case study of Islami Bank Bangladesh Limited. Khulna University Business Review, 53-64. doi:10.35649/kubr.2017.12.12.6

Turlington, J., Fafatas, S., & Oliver, E. G. (2019). Is it US GAAP or IFRS? Understanding how R&D costs affect ratio analysis. Business Horizons, 62(4), 427-436. doi:10.1016/j.bushor.2019.03.011