Which balance sheet ratios matter most for credit risk?

1. Solvency ratios: understand the financial structure

Solvency ratios indicate how the business is financed and how much financial pressure its debt may create. Shareholders own the company; lenders and suppliers are creditors, not owners.

Debt-to-equity ratio

Formula: Total interest-bearing debt ÷ Shareholders' equity.

This definition focuses on financial debt. Some analysts use total liabilities instead; always specify the convention used. Higher leverage may increase vulnerability to interest-rate changes, earnings volatility and refinancing difficulties. Negative or very low equity requires particular care because the ratio can become misleading.

Long-term bank debt to equity

Formula: Long-term bank borrowings ÷ Shareholders' equity.

The original article suggested that this ratio should never exceed 1. In practice, there is no universal threshold: acceptable leverage depends on cash generation, sector, asset structure and financing conditions.

For a more conservative view of capital strength, see Tangible Net Worth (TNW).

2. Liquidity ratios: can the customer meet short-term obligations?

A ratio above 1 is not automatically evidence of good credit quality. Overdue receivables, obsolete inventory, restricted cash and the timing of liabilities can all distort the picture. Conversely, some stable businesses operate with low current ratios because of fast cash conversion and reliable financing.

3. Working capital efficiency: DSO, DPO and inventory days

Days Sales Outstanding (DSO)

Approximate formula: Average trade receivables ÷ Credit sales × Number of days in the period.

DSO estimates how long customer invoices remain outstanding. Where credit sales are unavailable, total revenue may be used as an approximation, provided the limitation is disclosed. Use a consistent basis for receivables and sales, particularly regarding VAT or sales tax. An increasing DSO may indicate longer agreed terms, collection problems, disputes, customer distress or a change in sales mix.

Days Payable Outstanding (DPO)

Approximate formula: Average trade payables ÷ Cost of goods sold × Number of days in the period.

DPO approximates the time taken to pay suppliers. Purchases are preferable to cost of goods sold when available and comparable. An unusually rapid increase can signal liquidity pressure, but it may also reflect negotiated terms or changes in procurement.

Days Inventory Outstanding (DIO)

Formula: Average inventory ÷ Cost of goods sold × Number of days in the period.

Inventory days indicate how long goods remain in stock. Compare them with industry norms, seasonality and product life cycles. There is no universal 20-day or 30-day target.

Cash conversion cycle (CCC) = DSO + DIO - DPO. This combined indicator helps explain the time between paying suppliers and collecting from customers. It should be interpreted alongside the company's business model.

For all day-based formulas, use 365 days for annual figures (or the actual number of days in the period) and apply the same convention consistently.

4. Identifying accounting red flags and potential misstatements

Financial statements may contain estimation errors, aggressive accounting assumptions or, in some cases, deliberate misstatements. Warning signs do not by themselves prove fraud. They indicate where further questions and supporting evidence are needed.

• Trade receivables increasing much faster than revenue, especially when DSO rises sharply.
• Large overdue balances without adequate expected credit loss allowances.
• Inventory values inconsistent with stock ageing, obsolescence or market demand.
• Unusual asset valuations, capitalised costs or related-party balances.
• Profits rising while operating cash flow deteriorates.

5. Case study: how unrecognised bad debts can conceal financial weakness

Consider the example in the original tutorial. The company reported revenue of €12.625 million and trade receivables of €4.983 million. It had €2 million of receivables that were effectively uncollectible but had not been written down.

Indicative year-end DSO: €4.983m ÷ €12.625m × 365 = 144 days. This uses closing receivables and total revenue, so it is a warning indicator rather than a precise average collection period.

The €2 million write-down would reduce the value of trade receivables and equity by the same amount. For simplicity, the illustration assumes the full loss is recognised in the period's operating profit and that there are no offsetting tax effects, recoveries or existing provisions. Actual accounting treatment depends on the applicable standards and facts.

According to the original case study, the company subsequently went bankrupt. The lesson is to challenge unusual figures and investigate receivables quality before granting or renewing a credit limit.

6. Turn ratio analysis into better credit decisions

Balance sheet ratios are most useful when assessed together, tracked over time and compared with sector benchmarks. Combine them with cash-flow analysis, payment experience, customer information and the commercial context before deciding on credit limits, payment terms or guarantees.

Continue with the tutorial on Tangible Net Worth or return to customer credit analysis.