Financial Institutions Lending - Essay Example

It is calculated by dividing total debts by total assets. A debt ratio of greater than1 indicates that a company has more debt than assets -a debt ratio of less than 1 indicates thata company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's level of risk. A lending risk assessment ratio that financial institutions and others lenders examine before approving a mortgage.Typically,assessments with high LTV ratios are generally seen as higher risk and, therefore, if themortgage is accepted,the loanwill generally cost the borrower more to borrow or he or she will need to purchase mortgage insurance.

A debt service measure that financial lenders use asa rule of thumbtogivea preliminaryassessment about whether a potentialborrower is already in too muchdebt.Receiving aratio ofless than30%means that the potential borrowerhas an acceptable level of debt. A general termdescribinga financialratio that compares some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.

The higher a company'sdegree of leverage, the more thecompany is considered risky. As for most ratios, an acceptable levelis determined by its comparisonto ratios ofcompanies in the same industry.The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).5. Solvency Ratio One of many ratios used tomeasure a company's ability to meet long-term obligations.

The solvency ratio measuresthe size ofa company's after-tax income, excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations.Thus, credit quality can best be evaluated by analyzing the probability of a company running out of both cash and profits at any given moment. To evaluate the possibility of a company running out of cash, lenders generally look at a cash budget for the firm.

They evaluate various scenarios and try to determine how likely the ending cash balance will be negative, implying a need for outside funds that may not be forthcoming if the company is not profitable. The extent of the credit losses that then arise if a firm does run out of cash is a function of the collateral or seniority status of each debt, as well as the value of the total assets of the company in bankruptcy.Essentially, credit analysis can be simply conducted by comparing the company's average Times Interest Earned (TIE) ratio over the past few years to that of the cross-sectional average TIE of groups of firms with the same public credit rating, such as the same Moody's or S&P letter rating for which public data are available.

Then set the company's starting credit rating equal to that which most closely matches the TIE of the firms with a given letter credit rating. Next, the trend in