Credit Rating Calculation: Unveiling the Process with S-peek - Liquidity
How to assess corporate liquidity
Credit rating measures a company's economic and financial balance, analyzing it from various perspectives to assess its creditworthiness.
But how is it calculated?
Together with modefinance's Rating Analyst Elisa Graffi, we are exploring the aspects considered by S-peek for rating calculation, detailing the ratios used by the MORE algorithm to assess the state of health of a business.
After analyzing solvency indices, which provide insights into a company's use of funding sources, this article explores the ratios used to assess the liquidity of the company – its ability to repay short-term debts.
Understanding the Current ratio: Definition and Calculation
The analysis of liquidity should be a continuous and integrated process in a company's financial management - explains Elisa Graffi. Only through constant monitoring can long-term financial stability be ensured, avoiding excessive reliance on debt."
One of the first metrics to calculate in order to assess a company's liquidity is the Current Ratio, which is also referred to as the primary liquidity ratio. The Current Ratio indicates the company's ability to pay off its short-term debts using its existing financial resources, as well as those that will become available in the near future.
The formula is as follows:
Current Ratio = Current Assets / Current Liabilities
The Current Assets, whose value can be found in s-peek's Extended12M reports, include the cash resources and those assets that can be converted into cash within a year. These include mainly stocks, receivables and specific financial assets.
Current liabilities, on the other hand, include all payables due within a year, whether financial (such as bank debts) or operational (such as debts to suppliers or employees, tax debts, accruasls and deferred liabilities).
What information can we obtain from the Current Ratio? If the ratio is above 1, the company has a sufficient amount of liquid resources (immediate or short-term liquidable) to meet its current debts, thus being in a financially balanced situation."
The Quick Ratio: the Essential Immediate Liquidity indicatorAnother crucial metric in liquidity analysis is the Quick Ratio, also known as the Acid Test. This ratio is computed by dividing Current Assets, excluding inventory, by Current Liabilities.
In simple terms, the reasoning behind this indicator is that inventory may not always be easily sold off quickly - Graffi explains. Therefore, it's important to consider whether only receivables and liquid assets are enough to cover short-term obligations.
Unlike the Current Ratio, outcomes lower than 1 are also appropriate, as long as they are not less than 0.5. However, it's important to remember that these values should be always compared to the industry averages. As Graffi explains,
"some sectors, such as the trade sector, have a much lower Quick Ratio compared to the Current Ratio due to the impact of inventory on total availability. On the other hand, sectors like consulting, services, and software, which don't involve inventory, will have a Quick Ratio almost equal to the Current Ratio. It's crucial to analyze each sector based on its characteristics to avoid drawing incorrect conclusions.
The Monetary Cycle: Analyzing Cash Flow Dynamics
Businesses often experience a time gap between selling their products, receiving payments, and paying their suppliers. This period is commonly known as the Monetary Cycle and varies depending on the nature of the business. Analyzing the monetary cycle is crucial for financial management because it affects a company's cash flow and liquidity. Ideally, a shorter monetary cycle is preferable because it means that a company can quickly convert inventory and receivables into cash. However, it's essential to consider the specific context of the company and its industry since the average times for collecting payments, paying suppliers, and rotating inventory can differ significantly between industries.
How to Calculate the Monetary Cycle
The timing of the Monetary Cycle can be estimated from the balance sheet data as follow. First, one needs to estimate its components, namely:
- Days Inventory Outstanding: this can be estimated by dividing the value of Active Stocks by Sales Revenue and multiplying the result by 365.
- Days Sales Outstanding: calculated by dividing the value of Receivables from Customers by Sales Revenue and multiplying the result by 365.
- Days Payable Outstanding: given by the ratio of Debts to Suppliers to Sales Revenue, also multiplied by 365.
Once these three components are estimated, it is possible to determine the timing of the Monetary Cycle as follows:
Montery Cycle = DIO + DSO – DPO
The greater the number of days in the Monetary Cycle, the greater the amount of resources needed to finance operational activities. In general, an extension of the Monetary Cycle has negative effects on financial balance because it indicates a greater gap between payment and collection times. As Elisa Graffi explains,
This could be due to longer inventory holding times (the company needs more days to turn inventories into cash), longer receivables collection times, or shorter debt payment times. Conversely, the ideal situation sees inflows preceding outflows.
In Conclusion: Key Liquidity Indicators and Beyond
The Current Ratio, Quick Ratio, and Monetary Cycle are important indicators of a company's liquidity that can be derived from publicly available financial statement data. Together with solvency indicators, they provide an overview of the company's ability to repay debts, whether they are financial or operational, with a a short or long term due.
In order to complete the assessment of a company's reliability, it is necessary to analyze its profitability, which reflects the ability to generate profit from its activities.
However, we will delve into this topic in the next and final article.
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