There are numerous qualitative measures that can indicate expected financial performance when evaluating credit risk in new and existing business relationships. However, it’s important to consider the key metrics that accompany the 5 Cs of Credit.
In addition to the Debt Service Coverage Ratio, it is important to measure and monitor a firm’s Net Profit Margin.
What does this mean?
Net profit margin is important because it fundamentally shows the profitability of a company, and serves as a predictor of a firm’s likelihood to default on loans. A proxy for efficiency, it shows how many cents in profit are generated by every dollar in goods or services sold.
Why is it important?
The net profit margin is important to evaluate in lending decisions because it effectively shows the firm’s potential net worth based on earnings. This has a direct effect on capital reserves, which means the higher the profit margin, the more likely the business will be able to remain resilient in periods of unexpected losses.
Make more informed lending decisions.
How to improve it?
According to Karen Berman and Joe Knight, coauthors of Financial Intelligence for Entrepreneurs, three possible fixes to a poor net profit margin are:
• Focus on reducing overhead expenses (though it may be a quick fix providing one-time savings),
• Increase sales volume so fixed costs are spread further, improving profitability, or
• Seek advice from customers as to how the company can optimize its offering, or find a new market (potentially boosting sales).
To learn more about which metrics mean the most in your credit analysis process, download the whitepaper Quantifying the 5 Cs: Credit Analysis Ratios that Matter.
