Question

How would a creditor use the financial statements to decide whether to extend credit to a company? What would the creditor look for in this decision-making process? Which of the financial statements is the most important? Why?

Answer 1

Financial statements provide comprehensive information about the financial health of an organization. They are useful for all the stakeholders, be it creditors, debtors, shareholders, government etc. Creditor can use the financial statements in multiple ways to take decision about whether to extend loan to a company or not in following ways:-

1.       Credit risk can be determined by calculating current ratio. Generally a ratio of more than 1:2 is accepted because it shows that business can fulfil its liabilities easily.

2.       Debt to equity ratio can be computed in order determine the ability of an organization to repay its debt.

3.       Return on investment can be computed which tells about the capability of an organization to earn from investments. Higher the return on investment, better it is.

4.       Contingent liabilities can be ascertained so that any hidden potential exposure can also be taken into consideration.

5.       Trends in sales margin is analysed in order to judge the revenue flow in organization. If it seems negative, then it can raise serious concern about the financial soundness of the company.

6.       Efficiency ratios is computed to measure how management is using the assets to generate sales and profits.

                                                                                                                                                                           

Creditors look following things in his decision making process:-

1.       Credit worthiness of the company with the help of various ratios mentioned above.

2.       Cash flow statements of the company.

3.       Repayment capacity of the company.

4.       Credit history

5.       Collateral available to secure the loan

Financial statements consist of Income Statement, Balance Sheet, and Statement of cash flows.

Income statement is the most important financial statement since:-

1.It explains the ability of business to generate profits.          

2.It is for one year complete year therefore there are very less chances for manipulation as compared to balance sheet that is for a particular date.

3.It shows the actual performance of the business.

4. It shows expenses incurred by the company.