Ratio Analysis for Bankers
Five ratios carry most lending decisions. Here they are, worked on one company's accounts with a basic calculator.
A credit officer reads ratios with one question in mind: can this borrower pay us, now and over the life of the loan? Ratios fall into four families: liquidity, leverage, activity (turnover) and profitability. For lending decisions, five carry most of the weight: current ratio, debt-equity ratio, total outside liabilities to tangible net worth (TOL/TNW), interest coverage and the debt service coverage ratio (DSCR).
Below, one small company's accounts are worked through all five. Every number comes from the two tables, so you can redo each step on a basic calculator.
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Worked Example: Balance Sheet of ABC Pvt Ltd (₹ lakh)
Share capital
₹ lakh
200
Assets
Net fixed assets
₹ lakh
540
Reserves and surplus
₹ lakh
150
Assets
Intangible assets
₹ lakh
30
Term loan (of which ₹80 lakh due within 12 months)
₹ lakh
400
Assets
Inventory
₹ lakh
380
Unsecured loans from promoters
₹ lakh
50
Assets
Trade receivables
₹ lakh
260
Cash credit from bank
₹ lakh
250
Assets
Cash and bank
₹ lakh
40
Sundry creditors
₹ lakh
150
Assets
₹ lakh
Other current liabilities
₹ lakh
50
Assets
₹ lakh
Total
₹ lakh
1,250
Assets
Total
₹ lakh
1,250
| Liabilities | ₹ lakh | Assets | ₹ lakh |
|---|---|---|---|
| Share capital | 200 | Net fixed assets | 540 |
| Reserves and surplus | 150 | Intangible assets | 30 |
| Term loan (of which ₹80 lakh due within 12 months) | 400 | Inventory | 380 |
| Unsecured loans from promoters | 50 | Trade receivables | 260 |
| Cash credit from bank | 250 | Cash and bank | 40 |
| Sundry creditors | 150 | ||
| Other current liabilities | 50 | ||
| Total | 1,250 | Total | 1,250 |
Profit and Loss Summary (₹ lakh)
| Item | ₹ lakh |
|---|---|
| Sales | 2,000 |
| Profit before depreciation, interest and tax (PBDIT) | 260 |
| Depreciation | 60 |
| Interest: term loan 45, cash credit 45 | 90 |
| Profit before tax | 110 |
| Tax | 28 |
| Profit after tax (PAT) | 82 |
The Five Lending Ratios, Worked
- 1
Current ratio = current assets / current liabilities
Current assets: 380 + 260 + 40 = 680. Current liabilities: cash credit 250 + creditors 150 + other 50 + term loan instalments due within a year 80 = 530. Current ratio = 680 / 530 = 1.28. The trap is the ₹80 lakh: the part of a term loan due in the next 12 months is a current liability. Net working capital = 680 minus 530 = ₹150 lakh. Quick ratio, which leaves out inventory: (680 minus 380) / 530 = 0.57.
- 2
Debt-equity ratio = long-term debt / tangible net worth
Tangible net worth (TNW) = share capital + reserves minus intangibles = 200 + 150 minus 30 = 320. Long-term debt = term loan due after a year 320 + promoters' unsecured loans 50 = 370. Debt-equity = 370 / 320 = 1.16. If the bank accepts the promoters' loans as quasi-equity (subordinated to the bank), debt falls to 320 and TNW rises to 370, giving 0.86. Rating agencies use a wider measure: CRISIL's gearing counts all debt, including cash credit, so (400 + 50 + 250) / 320 = 2.19. Use the definition the question gives.
- 3
TOL/TNW = total outside liabilities / tangible net worth
Outside liabilities are everything except the owners' funds: 400 + 50 + 250 + 150 + 50 = 900. TOL/TNW = 900 / 320 = 2.81. Unlike debt-equity, this includes creditors and bank working capital, so it shows total dependence on outsiders.
- 4
Interest coverage = PBDIT / interest
260 / 90 = 2.89 times. Operating profit covers all interest almost three times over. This is the ratio CRISIL uses for the cushion a company has to meet interest from operations.
- 5
DSCR = (PAT + depreciation + interest on term loan) / (interest on term loan + term loan instalment)
Numerator: 82 + 60 + 45 = 187. Denominator: 45 + 80 = 125. DSCR = 187 / 125 = 1.50. The numerator adds back depreciation because it is a non-cash charge, and adds back interest because interest is also in the denominator. RBI's IRAC master circular defines the same numerator, EBID, as PAT + depreciation + interest on debt + lease rentals. A DSCR above 1 means the year's cash covers the year's debt service.
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Benchmarks: Read Them as Ranges
No single RBI number applies to every bank. These are the figures quoted in different sources, set against ABC's results.
Current ratio
Benchmarks quoted
1.33 in most sources; one bank accepts 1.25 (1.10 for export units)
ABC Pvt Ltd
1.28
Reading
Below 1.33, within that bank's 1.25 acceptable level
Debt-equity
Benchmarks quoted
2:1 to 3:1 in study notes; 3:1 in one bank's policy (4:1 infrastructure)
ABC Pvt Ltd
1.16
Reading
Comfortable
TOL/TNW
Benchmarks quoted
3.0 in study notes; up to 4:1 in one bank's policy
ABC Pvt Ltd
2.81
Reading
Within both
DSCR (average)
Benchmarks quoted
1.5 to 2 in most notes; 1.5 average with 1.10 minimum in one bank's policy; some notes quote net 2 and gross 1.75; Wikipedia cites 1.2 for commercial banks
ABC Pvt Ltd
1.50
Reading
Meets the lower end; a stricter bank would want more
Interest coverage
Benchmarks quoted
No common benchmark in the sources; higher is safer
ABC Pvt Ltd
2.89
Reading
Adequate cushion
| Ratio | Benchmarks quoted | ABC Pvt Ltd | Reading |
|---|---|---|---|
| Current ratio | 1.33 in most sources; one bank accepts 1.25 (1.10 for export units) | 1.28 | Below 1.33, within that bank's 1.25 acceptable level |
| Debt-equity | 2:1 to 3:1 in study notes; 3:1 in one bank's policy (4:1 infrastructure) | 1.16 | Comfortable |
| TOL/TNW | 3.0 in study notes; up to 4:1 in one bank's policy | 2.81 | Within both |
| DSCR (average) | 1.5 to 2 in most notes; 1.5 average with 1.10 minimum in one bank's policy; some notes quote net 2 and gross 1.75; Wikipedia cites 1.2 for commercial banks | 1.50 | Meets the lower end; a stricter bank would want more |
| Interest coverage | No common benchmark in the sources; higher is safer | 2.89 | Adequate cushion |
Activity and Profitability Ratios on the Same Accounts
- check_circleInventory holding: 380 / 2,000 × 365 = about 69 days of sales. Exam questions may instead use cost of goods sold; use whatever base the question gives.
- check_circleReceivable days: 260 / 2,000 × 365 = about 47 days.
- check_circlePAT margin: 82 / 2,000 = 4.1%.
- check_circleReturn on capital employed: PBIT / (total debt + net worth) = 200 / (400 + 50 + 250 + 350) = 200 / 1,050 = 19.0%.
Clean Up Net Worth Before You Divide
Tangible net worth leaves out intangibles and anything that is not real owners' money. CRISIL excludes revaluation reserves and miscellaneous expenditure not written off. A revaluation of land raises reported net worth without adding a rupee of cash, and makes TOL/TNW look better than it is.
How the IIBF Exam Tests This
- check_circleComputation from a given balance sheet: current ratio, TOL/TNW and DSCR are the favourites. Watch the current portion of the term loan and the intangibles.
- check_circleFormula recall: DSCR's numerator adds back depreciation and interest; the denominator is interest plus principal due in the year.
- check_circleClassification: current and quick ratio are liquidity; debt-equity and TOL/TNW are leverage (solvency); inventory and debtor turnover are activity; margins and RoCE are profitability.
- check_circleBenchmarks: current ratio 1.33 is the figure most questions expect. For DSCR, TOL/TNW and debt-equity, read the options against the question's own data.
FAQs
What is the ideal current ratio for bank lending?expand_more
1.33 is the benchmark most often quoted for working capital lending. Some banks accept slightly lower, such as 1.25, and lower still for export units.
How do you calculate DSCR?expand_more
Divide the cash available for debt service (PAT + depreciation + interest on the term loan) by the debt service due in the year (term loan interest + principal instalments). Above 1 means the year's cash covers the year's repayments.
What is the difference between debt-equity and TOL/TNW?expand_more
Debt-equity compares long-term debt with tangible net worth. TOL/TNW compares all outside liabilities, including creditors and working capital borrowings, with tangible net worth, so it is always the larger ratio.
What is a good DSCR for a term loan?expand_more
It depends on the bank's policy. Sources quote averages from 1.5 to 2. One bank's 2019 policy asked for an average of 1.50 with no year below 1.10.
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