Simply, because the creditor wants to ensure the borrower has the ability and wherewithal to pay back the loan. Sure, the creditors have done their due diligence on the underlying business before releasing funds to the borrower.
Most users of the financial statements will think that income statement is the most important as it shows the profitability of a company Also see Accounting — 4 Tips for Analyzing an Income Statement. Besides, most of the information on the income statement is in current dollars. Also, the information listed on the income statement is mostly in relatively current dollars, and so represents a reasonable degree of accuracy.
Details such as income, existing debt obligations, expenses, salaries, profit and cash flow all factor into the overall business financial profile.
Creditors use financial statements to determine if the business represents a sound credit risk, as well as its ability to repay debt as agreed. Learn about the possible risks that these transactions may present, including misstatement of accounts and fraudulent financial reporting.
Long-term creditors want to ensure that a company will pay its outstanding debts. This website uses cookies to improve your experience. Some of the factors that creditors use to evaluate the creditworthiness of borrowers include: Financial stability of the borrower, including an assessment of their liquidity, profitability, cash flow, and capital structure.
The amount of existing liabilities. Has the borrower been punctual in repaying loans in the past? The availability of suitable assets for collateral. The extent to which the earnings of a business can cover interest payments.
The sensitivity of earnings and cash flows. How do the financial plans and cash flow projections of the business affect its credit risk. How do creditors Reduce Credit Risk?
Some strategies used by creditors to reduce credit risk include: Offering goods and services to customers on a cash basis. Offering credit to only to established customers. Checking the credit history of a borrower before issuing a loan. Defining a credit limit for each borrower that sets the maximum amount that can be borrowed.
Charging interest rate depending on the risk profile of a borrower. A higher rate of interest is charged to compensate for lending to high-risk clients. Allowing a lesser credit period to risky clients. Offering loans only to borrowers having suitable assets for collateral. Imposing loan covenants that obligate the borrower to: Use the loan only for the designated purpose. This ratio gives creditors an understanding of how the business uses debt and its ability to repay additional debt.
The formula for determining debt-to-equity is total business liabilities divided by shareholder's equity. How creditors evaluate the debt-to-equity ratio varies depending on the type of business or industry. Creditors analyze business financial statements to determine how a business will repay a loan or additional debt, with cash flow considered the primary source of debt repayment.
Since existing cash flow may not be enough to cover additional debt, creditors look for growth trends, one-time expenses that affected cash flow, debt elimination, discretionary spending and expiring obligations to estimate future cash flow. Current debts are obligations payable within a year. A high promotion of current assets to debt shows you can cover existing debt commitments and potentially take on new debt. The quick ratio is another common leverage ratio.
The primary difference from the current ratio is that the quick ratio leaves your inventory balance out of the current asset total. Inventory drives your business' revenue, so practically speaking, you can't liquidate it to cover debt because it leaves you with no means of generating revenue.
This ratio is often referred to as the "acid test' because it paints a clear picture as to how leveraged your business is in the short-term. In some cases, creditors have a vested interest in your assets when you apply for a secured loan. A common example is when you look for a building loan.
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