Creditors are interested in the financial statements of businesses to learn about the status of their going concern, profitability, financing, liquidity, and cash flow.
Going Concern
An entity is a going concern if it is likely to remain in business for the foreseeable future without going into bankruptcy.
A borrower going bankrupt is bad news for its creditors because they may never recover the full amount of their loans despite lengthy and costly legal proceedings.
Creditors, therefore, want to monitor the going concern status of borrowers regularly to identify any serious problems that could lead to their bankruptcy.
Some critical indicators from the financial statements of borrowers that may point towards going concern problems include:
- Auditors not providing an opinion on the going concern status of a business or highlighting financial problems in their audit report.
- Financial statements not prepared on a going concern basis.
- Pending legal cases against the borrower that can be detrimental to its business.
- Significant losses declared in consecutive accounting periods.
- Reliance on short term borrowing to finance long term projects.
- Inability to pay dividends to shareholders.
- An adverse trend in profitability, financing, and liquidity ratios.
Profitability
Profitability is necessary for sustaining any business in the long term. Before committing to lend substantial amounts of money, creditors need to ensure that the borrower has enough earning potential to allow the return of funds.
Creditors look for the following factors in financial statements when assessing the profitability of a business:
- How do the profit margins of business compare to the industry average?
- What is the yearly trend of profits, and what internal and external factors are contributing towards the trend?
- Do the profits of a business come from a single product or service, or are the earnings well diversified?
- How sensitive are profits to changes in consumer tastes and spending power?
- What is the distribution of fixed and variable expenses?
Financing
The reliance on debt in financing a business affects the level of risk associated with its loans.
Businesses tend to ‘gear up’(increase borrowing) in the hope of making more money than the cost of debt.However, as the proportion of debt in a business increases, the risk of bankruptcy also increases. This is because the cost of debt can escalate significantly in the future in line with market rates, even if the earnings of a business are on the decline.
Creditors can measure the financial gearing (debt-to-equity ratio) by dividing the total debt (short and long-term)of business by the amount of total equity reported in the balance sheet.
Liquidity
Creditors need to know how easily a borrower can pay its short term obligations because an inability to pay off debts can force the business to file for bankruptcy.
A common measure of liquidity is the quick ratio that shows the proportion of cash and other liquid assets available to a business that can be used to pay off its short term liabilities in case of an emergency.
Cash Flow
Creditors are interested in knowing about the spending habits of borrowers before lending out a loan.
The cash flow statement shows the sources of funds flowing into a business, as well as the distribution of cash outflows.
Creditors are particularly looking for:
- How has the business prioritized its expenditures between operational, investing, and financing activities?
- Is the business investing sufficient funds into long term assets, research, and development that is necessary for long term growth?
- How much of the reported income is getting help up in receivables?
- How many funds are reserved for paying interest and principles of loans?
