Question

4 months ago Anonymous using the Financial Statement for Decision Making How would a creditor use the financial statements to decide whether to extend credit to a c ompany? What would the creditor look for in h of the financial statements is the most important? Why? Reply

Answer 1

Step 1

The question relates to decision making process for extending credit to a company.

The decision making process require carefully analyzing the financial position of a company, its liquidity position, credit worthiness, etc.

Based on all these factors, the answer to the given question is given below:

Step 2

Before extending credit to a company, creditor has to review the financial position of the company, Reviewing a financial statement is important to the creditor to determine the creditworthiness of the company.

Determining the financial health of the company requires more than looking at the balance sheet.

Creditor must calculate how some of the information compare with other data.

The calculations yield some financial ratios which can be compared to accepted business patterns or data from other similar business.

Some of the important ratios n this concept are discussed below:

Current Ratio

A comparison of the ration between current assets and current liability can determine the liquidity of the business or the ability of the business to meet short-term obligations. Current assets will usually be converted to cash within one year and include cash and securities as well as inventory and receivables. Current liabilities are obligations payable within one year. The ratio between current assets and current liabilities is called Current Ratio. Creditors generally wants to see at least a 2:1 ratio or say twice as many current assets as current liabilities, but acceptable ratios may vary.

Quick Ratio

In current assets, inventory is also included, but inventory some times can be more difficult to turn quickly. In such circumstances, creditor worked out Quick Ratio. For calculation Quick Ratio, inventory is excluded from the current assets. In this ratio assets which are quick to be converted into liquidity are considered. In Quick Ratio, assets like cash, marketable securities, accounts receivables, etc are considered. This ratio must be used carefully and in conjunction with other data due to business variations. For example, some companies can turn inventory into cash more quickly than others can collect receivables.

Debt- to- Equity ratio

This ratio compares liabilities with the Company's total equity. This shows how much of the company is financed by debt compared to the amount finances by equity. Watching this value over time shows developing trends. If the ratio is increasing, the business could be at risk from taking on too much debt. This is a good indicator of the solvency of the business or its ability to continue operations long-term.

Receivables Turnover

In this ratio, total amount of receivables and total amount of collection for a specific time is compared. If the receivables turnover is increasing, the business could have a problem collecting its accounts. This could lead to problems paying business obligations.

Interest Coverage Ratio

The interest coverage ratio shows how well the business may cover its future loan payments. Divide the total operating cash flow, which is earnings before taxes and interest, by the total amount of interest paid on business loans. This is the interest coverage ratio. A ratio of higher than 3- t0- 1 indicates that the company should be able to make future payments. If the ratio drops below this level, the business could have too much debt in relationship to its income.

Step 3

Based on above mentioned information, he creditworthiness of the company is determined by the creditor and decide whether to extend the credit to a company or not.