Question

Given the current regulatory environment for financial institutions, analyzing financial statement information is an important process and at the same time, the massive amount of information that creditors have to sort through can become unwieldy. Review the financial ratios in the text, and choose three or four that creditors would mostly likely use to make their lending decisions. Indicate a rationale for choosing each ratio. Discuss at least three ways that management might manipulate the financial data to guarantee that the lending decision will be made in its favor. Provide specific examples.

Financial ratios:

working capital, current ratio, quick ratio,inventory turnover, debt to equity, accounts receivable turnover, days sales in account receivable.

Answer 1

Creditors would normally use the following financial ratios for their lending descions:

Current ratio

1.One of the t ratios a lender resorts to is the current ratio. This is calculated by dividing current assets by current liabilities.

2.This indicates a company's liquidity and its ability to pay short-term obligations and liabilities using its current resources.

3. Under normal circumstances a lender is looking for this number to be greater than or equal to one because this will show that current assets are at least equal to current liabilities.

4. This lets the lender know that all current obligations can be met smoothly within the reasonable time.

5, The adequacy of a current ratio will depend on the type and nature of the business and the character of the current assets and current liabilities. Normally there is certainty about the amount of debts that are due, but there is a certain amount of uncertainity as regards the quality of accounts receivable or the cash value of the stock or inventory. That leads to many a times an insistence for a safety margin.

Quick Ratio

1.The quick ratio (sometimes called the acid test) is a ratio that is like an extension to the current ratio as this also focuses on the liquidity of the company but it is a little more restrictive.

2. This ratio is derived by subtracting inventory from current assets and this total is divided by current liabilities.

3. Inventory is not easily convertible fully into cash value within a short period of time.

4. A lending institution may want to compare the quick ratio to the current ratio if a significant amount of current assets i.e a substantial amount of funds are blocked in inventory or are held as inventory.

5. A normal rule is that ,higher the number the better, but the minimum number should be greater than or equal to one.

Ways in which the management can manipulate the financial data in order to guarantee that the lending decision is made in its favor are as follows:

1. The management should exaggerate the earnings or income of the current period in the income statement by artificially inflating revenue and gains, or by deflating current period expenses. This approach makes the financial condition of the company look better than it actually is in order to meet established expectations from the view point of the lenders..This could be done by Recording the Revenue Prematurely or by recording the revenue which is of Questionable Quality or by recording the revenue that is in fact not there i.e by recording the fictitious revenue. Similarly deflation of the expenses could be done by moving or shifting the Current Expenses to an earlier or later Period or may even go to the extent of not Recording or Improperly reducing the liabilities in an Improper manner and thereby making the company’s financial data appear better than what it is in reality.

2. The management may sometimes manipulate cash flow in order to make it appear higher than it otherwise should. A high cash flow indicates or is a sign of financial health and well being . A better cash flow can result in higher ratings when they approach the lenders for a loan and that in turn results in lower interest rates. Companies often finance their operations either by raising equity capital or going in for debt, and it is extremely important and useful to be able to present a picture of an healthy company

3. Companies many a time generate income from operations that are not related to their routine or normal business operations. The income that is not a routine business income could be in the form of an income from trading in the securities market. These normally would be the short-term investments and have no relation or connection to the strength of the business's core model. If the company ends up including these funds into its normal cash flow, it sends out an impression that the company generates more receivables from the functioning of its routine and normal business operations on a regular basis than it actually had done.

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Debt to equity ratio

1. A lender prior to sanctioning further debt or loan , does an examination and an in-depth analysis of the current debt to equity balance.

2. Total debt divided by shareholder equity will represent and detail out to the lender a snapshot of how a company has been financing its growth till that point.

3. A high number for the debt equity ratio may indicate that a business may not be able to sustain such growth and may experience problems when it comes to meeting its obligations.

4. The number with regards to the debt equity ratio can vary considerably by individual company and the weight of this ratio is studied significantly on a case-by-case basis.