Reply 1 to discussion (Financial Statement Analysis)

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Key Financial Ratios for bank providing long-term loan
When analyzing financial statements, various creditors and investors focus on different
ratios to assess a company’s financial health and performance. For instance, in the case of banks
offering loans, a thorough analysis of the borrower’s financial statements becomes paramount to
assess the borrower’s creditworthiness and the potential risks associated with the loan (Widagdo
et al., 2020). This paper explores three specific financial ratios relevant to banks providing longterm loans.
Debt-to-Equity Ratio
The debt-to-equity ratio is one of the first important ratios for banks regarding long-term
lending. This ratio shows how much of a company’s funding is provided by equity or debt. A
greater debt-to-equity ratio for the business is indicated by increased debt financing instead of the
issue of equity shares. A bank offering long-term loans must monitor prospective borrowers’ D/E
ratios to assess the borrowing company’s leverage and solvency. A high debt-to-earnings ratio
implies a greater financial risk for the company because it shows that it depends largely on debt
financing, which may make it difficult to pay off debt (Tamplin, 2022). Banks prefer borrowers
with a moderate and manageable debt-to-equity ratio (D/E ratio) because it shows a healthy
balance between debt and equity; a lower D/E ratio indicates that the company has sufficient equity
to pay its debts, lowering the default risk. Therefore, a careful examination of the D/E ratio aids
the bank in determining whether the borrower can afford long-term debt payments without
endangering their financial stability.
Interest Coverage Ratio (ICR)
The second financial ratio ICR is used to assess a company’s ability to pay interest on its
outstanding debts is the Interest Coverage Ratio (ICR). This ratio is calculated by dividing the
company’s earnings before interest and taxes (EBIT) by interest expenses (Tamplin, 2022). This
ratio is vital to banks providing long-term loans as it assists in assessing how risky it is to lend
money to a company based on the borrower’s ability to generate sufficient operating income to
cover interest expenses. “Times interest earned” is another name for the interest coverage ratio.
Given that the company has a larger margin to meet its interest obligations, a higher interest
coverage ratio indicates a lower default risk (Widagdo et al., 2020). On the other hand, a reduced
ICR might show possible difficulties in repaying debt, which would worry the lender. Strong
interest coverage ratios assure banks that borrowers will be more likely to be able to make their
interest payments throughout an extended loan tenure, which is why they favor individuals or
businesses with such ratios.
Return on Assets (ROA)
A bank that offers long-term credit loans must also pay close attention to return on assets
(ROA). This financial ratio shows an organization’s profitability relative to its total assets. Its
analysis aids in figuring out how profitably a business uses its assets. A company’s net income and
average assets are typically used to express the metric as a percentage (Tamplin, 2022). A higher
return on assets (ROA) indicates a borrower’s increased ability to fulfill long-term financial
obligations and a company’s ability to manage its balance sheet profitably. Conversely, a lower
ROA shows more room for expansion and a larger likelihood of loan default. Therefore, a bank
providing loan term loans would prefer to work with a client with a healthy ROA to minimize risk.
Conclusion
A bank that offers long-term loans evaluates the creditworthiness and stability of potential
borrowers based on several important financial ratios. Through a meticulous examination of the
Debt-to-Equity Ratio, Interest Coverage Ratio (ICR), and Return on Assets (ROA), financial
institutions can make well-informed decisions that mitigate the risks linked to extended lending.
These ratios also help ensure the borrower and lending institution’s sustainable financial health.
Reference
Tamplin, T. (2022). The Handy Financial Ratios Guide: A Comprehensive Guide to 140 Common
Financial Ratios Kindle Edition
Widagdo, B., Jihadi, M., Bachitar, Y., Safitri, O. E., & Singh, S. K. (2020). Financial Ratio, Macro
Economy, and Investment Risk on Sharia Stock Return. The Journal of Asian Finance,
Economics and Business, 7(12), 919926. https://doi.org/10.13106/jafeb.2020.vol7.no12.919