Learning objectives
By the end of this chapter you should be able to:
- Calculate and interpret liquidity, efficiency, leverage and coverage ratios to assess a customer’s ability to pay.
- Spot early warning signs in financial statements that may indicate rising credit risk.
- Adjust ratio-based conclusions for seasonality, accounting policy choices and one-off items.
- Combine financial statement evidence with non-financial information to set sensible credit terms.
- Use analysis outcomes to support practical credit decisions and ongoing risk monitoring.
Overview & key concepts
Granting credit converts a sale into a financing decision: you supply goods or services now and wait for cash later. Financial statements help you judge whether a customer is likely to pay in full and on time, and whether their financial position can absorb shocks (margin pressure, interest rate rises, weak trading periods).
A credit assessment typically draws on:
- Liquidity: short-term ability to settle obligations as they fall due.
- Working capital structure: how much funding is tied up in inventory and receivables, and how much is supported by supplier credit.
- Efficiency: how quickly the customer converts sales into cash and how long cash is tied up in operations.
- Leverage and coverage: how much the customer relies on borrowed funds and how safely they can service interest.
- Quality of earnings: whether profits are repeatable, cash-backed and not heavily distorted by accounting choices or one-off items.
Ratios are most useful when applied across time (trend) and against peers. A single ratio or a single year rarely supports a safe credit decision on its own.
A practical credit assessment workflow
A repeatable approach helps keep analysis focused and exam-ready:
- Screen liquidity and working capital (can the customer pay in the near term?)
- Test operating efficiency (is cash tied up or being released?)
- Assess leverage and debt servicing (could funding pressure trigger a payment problem?)
- Check earnings quality and comparability (are profits sustainable and comparable?)
- Overlay context (seasonality, business model, and non-financial evidence)
- Convert the story into credit controls (limit, terms, security, monitoring triggers)
Core theory and frameworks
1) Liquidity and working capital
Liquidity ratios look at the short-term cushion of resources against short-term obligations. For credit decisions, the key question is not simply “are current assets higher than current liabilities?”, but whether current assets are usable for paying suppliers.
Net working capital (NWC)
NWC = Current assets − Current liabilities
A positive NWC is not automatically “good”: some businesses operate with low or negative NWC because they collect cash quickly and pay suppliers later. You are assessing whether the working capital structure is stable and financeable.
Current ratio
Current ratio = Current assets / Current liabilities
A high current ratio is only reassuring if current assets are realisable in time and at realistic values.
Quick ratio
Quick ratio = (Current assets − Inventory) / Current liabilities
The quick ratio is often more relevant for supplier credit because inventory may be slow-moving, seasonal or subject to valuation risk.
What a supplier should ask when ratios look strong
A high current ratio can be driven by inventory. If most of the “cushion” is stock, ask: “Could this inventory be converted to cash quickly and at sensible values, and would that cash realistically be available to pay suppliers?”
2) Efficiency: how cash is tied up in operations
Efficiency ratios translate balance sheet balances into “days”, helping you understand cash flow pressure.
Receivables days
Receivables days = (Trade receivables / Credit sales) × 365
If only total revenue is available, it is common to use revenue as a proxy, but interpret cautiously where cash sales are significant.
Inventory days
Inventory days = (Inventory / Cost of sales) × 365
A rising inventory days figure can indicate slow-moving stock, overstated values, weak demand, or purchasing ahead of need.
Payables days
Payables days = (Trade payables / Credit purchases) × 365
Use trade payables only: other current liabilities (such as accruals, tax payable, deferred income, payroll liabilities) are not supplier credit. Only interpret payables days when the numerator is trade payables and the denominator reasonably approximates credit purchases (cost of sales is a common proxy when purchases are unavailable, but it can mislead where inventory levels change significantly).
3) Leverage and coverage: funding risk and resilience
A customer can appear liquid at year end but still be risky if debt levels are heavy and interest costs are hard to service.
Debt-to-equity (gearing)
For supplier credit analysis, a common and useful version focuses on interest-bearing funding:
Debt-to-equity = Interest-bearing debt / Equity
This version targets obligations that create finance cost and refinancing risk. If cash balances are material, consider net debt (interest-bearing debt minus cash) to avoid overstating leverage. Also watch for lease liabilities: they are debt-like commitments and can be material.
Interest cover
Interest cover = Operating profit / Finance costs
Operating profit is typically after depreciation/amortisation and can be affected by presentation choices (for example, non-trading “other income” included above finance costs). Always check whether operating profit includes non-trading items presented above finance costs, because these can inflate interest cover without improving the underlying ability to pay.
4) Quality of earnings: one-offs, accounting choices, and cash reality
Ratios are only as reliable as the figures behind them. Common distortions include:
One-off items
Material gains or losses that are not expected to repeat can distort operating profit, margins and coverage ratios. For credit decisions, remove them to estimate sustainable trading profit.
Accounting policy choices and estimates
Accounting choices can change reported profit and balance sheet values without changing cash. Inventory measurement methods, write-down discipline, depreciation assumptions, capitalisation decisions and revenue timing judgments can all alter ratios.
If a policy changes during the year, you may not be able to adjust ratios reliably without note disclosure. Without a quantified impact, the correct response is to flag comparability risk and seek evidence (for example, restated comparatives, quantified effect in the notes, or management explanation supported by data).
Cash versus profit (triangulation point)
Profit does not pay suppliers; cash does. Strengthen any ratio conclusion by checking whether operating cash flow supports reported profit, and whether working capital is absorbing or releasing cash. Warning signs include rising receivables and inventory alongside flat or weakening operating cash flow.
5) Trend, peer comparison, and limitations of ratio analysis
Ratios are most persuasive when supported by trends and peer comparison. Even then, ratio analysis has limitations:
- Window dressing around year end (accelerating collections, delaying payments, short-term borrowing to boost cash).
- Classification choices (what is included within operating profit; what is treated as operating versus financing).
- Aggregation: total figures can hide poor-quality receivables or obsolete inventory.
- Industry comparability: business models differ (cash retail versus contract sales; asset-light versus asset-heavy).
- Timing effects such as seasonality and cut-off.
These limitations are why credit decisions should combine ratios with cash flow evidence and non-financial information.
6) Non-financial evidence for credit terms
Financial statements mainly address capacity to pay. You should also consider evidence relevant to willingness and timing, such as:
- Payment history and dispute patterns with suppliers.
- Customer concentration and dependence on key contracts.
- Management quality and reporting reliability.
- Access to committed funding and refinancing timetable.
- Group support (parent guarantees, group treasury support, cross-default links).
- Events after the reporting date (refinancing, covenant breach, major customer loss, legal claims, post year-end trading deterioration).
Worked example
Narrative scenario
Northbank Traders is a medium-sized retail business applying for a credit line from a key supplier. The supplier wants an assessment of Northbank’s financial health using the most recent annual figures. The year end is immediately after the peak sales season.
The following information relates to the year ended 31 December:
- Revenue: £1,135,000
- Cost of sales: £987,800
- Operating profit (as reported): £149,620
- Finance costs (interest): £36,000
- Year-end inventory: £174,000
- Trade receivables: £113,500
- Cash: £18,000
- Trade payables: £87,000
- Other current liabilities: £43,500
- Interest-bearing loans (total debt): £191,000
- Equity: £136,500
- Included in operating profit is a one-off gain of £20,000 on disposal of a non-current asset
- The company changed its inventory valuation method during the year, affecting reported profit
- The year end falls immediately after peak season, affecting inventory and payables balances
Required
- Calculate liquidity ratios (current ratio and quick ratio).
- Calculate efficiency ratios (receivables days, inventory days, payables days).
- Calculate leverage and coverage ratios (debt-to-equity ratio, interest cover).
- Assess the impact of the one-off gain and the inventory policy change on the analysis.
- Recommend credit terms based on the evidence.
Solution
Step 1: Liquidity ratios
Current assets:
Inventory £174,000 + Trade receivables £113,500 + Cash £18,000 = £305,500
Current liabilities:
Trade payables £87,000 + Other current liabilities £43,500 = £130,500
Current ratio = Current assets / Current liabilities
Current ratio = £305,500 / £130,500 = 2.34 : 1
Quick ratio = (Current assets − Inventory) / Current liabilities
Quick ratio = (£305,500 − £174,000) / £130,500 = £131,500 / £130,500 = 1.01 : 1
So what (supplier actions):
- Liquidity looks comfortable on the current ratio, but the quick ratio is only marginally above 1.
- Initial controls should focus on inventory and receivable quality (evidence requests and tighter monitoring) rather than assuming the balance sheet is “cash-like”.
Step 2: Efficiency ratios
Using revenue as a proxy for credit sales, and cost of sales as a proxy for purchases (noting the limitations):
Receivables days = (Trade receivables / Revenue) × 365
Receivables days = (£113,500 / £1,135,000) × 365 = 36.5 days
Inventory days = (Inventory / Cost of sales) × 365
Inventory days = (£174,000 / £987,800) × 365 = 64.3 days
Payables days = (Trade payables / Cost of sales) × 365
Payables days = (£87,000 / £987,800) × 365 = 32.1 days
So what (supplier actions):
- Receivables days around 37 suggests credit terms may be around one month, but confirm by looking at ageing and post year-end receipts.
- Inventory days is significant, and the timing (post-peak season) may inflate the figure; request inventory ageing or evidence of post year-end sell-through.
- Payables days of 32 does not indicate stretching on its own, but it should be compared to stated supplier terms and any evidence of late payments.
Step 3: Leverage and coverage ratios
Debt-to-equity (interest-bearing debt focus):
Debt-to-equity = Interest-bearing debt / Equity
Debt-to-equity = £191,000 / £136,500 = 1.40
Interest cover (reported):
Interest cover = Operating profit / Finance costs
Interest cover (as reported) = £149,620 / £36,000 = 4.16 times
So what (supplier actions):
- Gearing is high, so the customer may be sensitive to trading downturns and refinancing events.
- Coverage looks acceptable at first glance, but must be tested for one-offs and profit quality before relying on it.
Step 4: Impact of the one-off gain and inventory policy change
(a) One-off gain
Adjusted operating profit:
Adjusted operating profit = Reported operating profit − One-off gain
Adjusted operating profit = £149,620 − £20,000 = £129,620
Adjusted interest cover:
Adjusted interest cover = Adjusted operating profit / Finance costs
Adjusted interest cover = £129,620 / £36,000 = 3.60 times
This reduces headroom. The ability to service interest still exists, but there is less buffer if profit falls.
(b) Inventory valuation method change
The direction and size of the effect cannot be determined from the data provided. Without quantified disclosure (for example, the impact on profit and inventory), you cannot make a reliable adjustment. The correct credit response is to flag risk and seek evidence, because the policy change may have:
- Increased closing inventory (improving current ratio, worsening quick ratio less than it should, lowering cost of sales).
- Increased reported profit (inflating margins and interest cover) without improving cash.
So what (supplier actions):
- Treat inventory and gross profit as higher-risk balances.
- Request explanations and corroborating evidence (inventory ageing, write-down policy, post year-end sell-through, and whether comparatives were restated or impacts quantified).
Step 5: Credit decision and suggested terms
Overall risk assessment:
- Liquidity appears strong on the current ratio, but the quick ratio is only just above 1 once inventory is removed.
- Working capital is inventory-heavy, and the year-end timing likely distorts inventory (and possibly payables).
- Leverage is significant, and interest cover falls to 3.60 times after removing the one-off gain.
- The inventory policy change adds comparability and valuation risk that cannot be quantified from the information provided.
Recommended decision:
- Approve credit, but on controlled terms consistent with medium credit risk.
Suggested terms (illustrative):
- A modest initial limit aligned to a short purchasing cycle (for example, two to four weeks of typical purchases).
- Standard payment terms, but staged limit increases only after a track record of on-time payment.
- Consider partial risk mitigants where commercially feasible (deposit on large orders, retention of title clauses where enforceable, or tighter delivery scheduling).
Monitoring and triggers:
- Monthly receivables ageing and evidence of post year-end cash collection patterns.
- Inventory monitoring (ageing, markdown trends, write-down discipline).
- Track interest cover using trading profit excluding one-offs, and watch for increases in debt, finance costs, or lease commitments.
- Watch for events after the reporting date (refinancing difficulties, covenant breaches, major customer loss) and any signs of supplier payment stretching.
Where credit assessments go wrong in practice
Many weak credit decisions come from treating year-end ratios as if they were a live cash position. A business can look “liquid” while cash is locked in slow stock, disputed receivables, or seasonal balances that unwind badly after the reporting date.
A second common failure is taking profit-based comfort measures (like interest cover) at face value without checking what drove the profit. A disposal gain, a policy change in inventory measurement, or aggressive revenue timing can lift operating profit while the cash position weakens.
Finally, analysis can fail when it ends with labels rather than controls. If the story is “inventory-heavy and geared, with limited headroom”, the response is not a generic risk category. It is a tighter starting limit, shorter review cycles, targeted evidence requests (ageing reports, post year-end collections, stock discipline), and clear escalation triggers if payment behaviour drifts or funding pressure rises.
A quick self-check before setting terms
- If inventory were removed, is there still a buffer?
- Do receivables convert to cash on time, or are they stretching?
- Is profit repeatable, and does it translate into operating cash?
- Does debt servicing remain safe under a mild downturn?
- What do payment behaviour and refinancing dates suggest about timing and willingness?
Summary
Financial statements support credit decisions by showing liquidity, working capital pressure, efficiency of cash conversion, and the burden of debt. Strong assessments combine:
- Liquidity ratios (current and quick),
- Efficiency ratios (receivables, inventory and payables days, using trade payables and sensible purchase proxies),
- Leverage and coverage (with a clear definition of debt and attention to lease liabilities),
- Adjustments for one-off items,
- Careful handling of accounting policy changes (flagging risk where impacts are not quantified),
- Cash flow triangulation (profit versus operating cash and working capital movements),
- Trend and peer comparison as the default lens,
- Non-financial evidence, including group support and post year-end events.
The aim is to reach a defensible view of payment risk and translate it into sensible credit terms and monitoring.
FAQ
How do liquidity ratios help when deciding whether to grant credit?
They indicate whether the customer has enough short-term resources to cover short-term obligations. For a supplier, the key is the quality of current assets: cash is directly useful, receivables depend on collection, and inventory depends on saleability and valuation. Use liquidity ratios alongside efficiency measures and cash evidence.
Why is trend analysis valuable in credit assessment?
A single year can be unusual due to timing, seasonality, or one-off events. Trends show whether working capital is tightening, leverage is rising, or coverage headroom is shrinking. Peer comparison helps you judge whether figures are normal for the sector or a sign of stress.
Why should one-off items be adjusted out?
They can lift or reduce profit without changing the customer’s ongoing ability to generate cash. Removing one-offs gives a better measure of sustainable operating performance and a more reliable interest cover ratio.
How can accounting policy changes affect ratio conclusions?
Policy changes can alter reported profit and balance sheet values without improving cash generation. If the impact is not quantified, you cannot adjust reliably: flag the risk, reduce reliance on affected ratios, and seek evidence such as quantified disclosures, restated comparatives, and supporting operational data.
What non-financial evidence strengthens a credit decision?
Payment behaviour, supplier references, contract stability, customer concentration, management reliability, committed funding, refinancing dates, group support or guarantees, and events after the reporting date (such as covenant breaches or major customer losses).
How does seasonality distort ratio analysis?
Year-end balances can be unusually high or low depending on the trading cycle. For a retailer after peak season, inventory and payables may be elevated. Use averages where possible and confirm conclusions with post year-end cash and trading evidence.
Glossary
Creditworthiness
A practical assessment of whether a customer is likely to pay suppliers in full and on time, considering financial capacity and payment behaviour.
Liquidity
The extent to which short-term resources can cover short-term obligations as they fall due.
Solvency (long-term financial resilience)
Whether the business can remain financially stable over time, including its ability to manage debt and withstand downturns.
Working capital
The net investment in short-term operating resources, measured as current assets less current liabilities.
Ratio analysis
Using relationships between financial statement figures to interpret performance, liquidity pressure and financing risk.
Trend analysis
Comparing measures across periods to identify improving or weakening patterns.
Gearing (leverage)
The extent to which a business relies on debt-like funding relative to equity.
Interest cover
A measure of how safely operating profit can meet finance costs.
Cash conversion
How efficiently reported performance turns into operating cash flows, influenced by receivables, inventory and payables movements.
Accounting policy
Chosen methods and estimates used in preparing financial statements, which can affect reported profit and asset values.
Exceptional / one-off items
Material gains or losses that are not expected to recur and can distort profitability and coverage measures if left unadjusted.
Covenant
A condition attached to borrowing (often ratio-based) that the borrower must comply with to keep facilities in place.