Why Is Evaluating Financial Statements Important to Creditors?

Creditors are parties the company owe money. A creditor may be a supplier who has delivered a service or supply goods to a company on credit. A creditor may also be a bank or an individual who has advanced credit to a company on the agreement to receive payment at a later date. Creditors are always grouped as liabilities in the companys balance sheet. Creditors who fall under the category of vendors are grouped as accounts payable whereas those that require a promissory note (a promise to pay a specific amount of money at a certain date in the future) are categorized as notes payable. Other examples of creditors are the company employees for whom the company owes salaries and wages, various statutory authorities as well as the government for who tax is owed to. Companies group their creditors as either short-term or long-term creditor.

Financial statements basically refer to a well-structured record of a companys financial activities for a specified period. These records and reports are presented in a manner easy for understanding for the users (Hunton, 2006). These financial statements include balance sheet which is a statement of the companys financial position and precisely focusing on the companys assets and liabilities. The next is a statement of changes in equity which gives details on changes in equity and retained earnings. Another financial statement is the income statement which analyses the companys incomes and expenses. The last one is a cash flow statement which groups the companys activities into operating, financing and investing activities. These financial statements are often accompanied by the management notes and analysis (Nizhneva, 2015).

Since creditors offer their services to the companys in anticipation of payment in the future, it is important that they are abreast of the company financial statements to track its financial performance. How well a company is performing financially will determine its ability to pay its creditors.

Creditors need the financial statements of a company to analyze the companys current ratio, the debt to equity ratio and the acid test ratio. The acid test ratio is important as it indicates the companys ability to meet their current debt obligations as they fall due. Creditors also use the debt to equity and the current ratio to determine the companys history of debt repayment as well as the velocity of repaying debts. The debt-equity ratio also enables the creditors to understand how the company uses its debt and its ability to pay debts.

Creditors are sometimes the sponsors of various company projects hence they need evidence supported explanation to where their funds went. Therefore, a financial statement clear details of the company asset investments and also explain on the outstanding debt obligations as well details on the profitability of the project.

Creditors also need the financial statements to analyze changing trends in sales gross margins as well as changes in the inventory turnover ratios. This analysis is important to help the creditors raise the alarm whenever the need arises so that the management can mitigate the possible solutions before the problems get out of control.

Creditors use financial statements to evaluate the companys viability to receive debt. These financial statements inform the creditors lending decisions to avoid investing their money in a company that is not likely to survive the foreseeable future.

b). Analyze how they do it?

Creditors can analyze financial statements first by using various financial ratios. Creditors can evaluate the financial statements by looking at either liquidity, profitability or gearing ratios. Using liquidity ratios creditors can evaluate the following items as follows:

Evaluation of assets for their quality

Creditors will evaluate the assets to establish their actual value behind the numerical figures presented on the balance sheet. They will also evaluate the current to find out the rate at which they can be converted into liquid cash. Creditors also evaluate the non-current assets to find their real value if plant attracts devaluation and analyze land to establish whether there is an additional value from revaluation.

Evaluation of accounts receivables

Creditors will ask questions on the companys credit terms to establish within what time the debtors are likely to repay. They will also assess who the company sells their products if they are firms with financial crises or well-established firms with a high possibility of repaying. Creditors also seek to establish if there is market diversity that is if the company sells to a wide range of customers as that will help mitigate the risks of default from only one client who the company sells to in large volumes. The balance sheet also helps the creditors to find out some of this information regarding accounts receivables by for example looking at the provisions made for doubtful debts and the bad debts written off.

Analyzing the inventories.

The creditors also look the financial statements for inventories. They seek to analyze the state of the inventories available and their store value. They also evaluate the actual state of inventories, finished goods and work in progress. They also analyze if there have been prior periods inventory loss in value that could push down the value on the balance sheet. They also look at the turnover ratio to find out after how long inventories are converted into sales (Saleem, 2011). This ratio is useful as it helps the creditors find out if the liquidity of a company is highly influenced by their inventories.

Gearing

Creditors also analyze the companys composition of long-term debt to equity. This ratio is an important tool which helps the creditors understand a firms financial direction in the foreseeable future (Welch, 2011). For example, a company that is highly geared has a high likelihood of collapsing shortly, and this analysis is important to come up with a contingency plan to shield creditors from losses (Delimatsis, 2013). Companies with high gearing ratios expose the unsecured creditors to losses. This evaluation is therefore important to inform the creditor of any need to collateralize their creditors. Another important gearing ratio is the interest cover. The creditors use this tool to find out how much of the companys funds are committed to interest on loan repayments and also their historical trends in debt servicing preference to critique if there are financially viable for their credit (Nimalathasan, 2010).

Analysis of cash flow items

Creditors will also analyze the cash flow items for its credit repayment ability. Companies pay their debts out of cash flows. So creditors will assess a firms financial strength based on its ability to generate cash constantly flows enough to meet its long-term debt obligations as they fall due (White, 2005).

Inter-related companies and related party transactions.

Companies can either be a source of credit for other companies or users of credits from other companies. In the event of any of the two creditors understand any intention to divert their funds, and to what use the funds are put. Sometimes it becomes dangerous when the creditor's funds are diverted to unclear uses making it dangerous for creditors to track their money. Therefore, an evaluation of financial records is necessary to keep the management on its toes and alert creditors on any intent to falsify use of their funds.

The last item of the financial statements that the creditors evaluate are the income statement items. Creditors will look at the gross profit and the net profits to determine the gross profit margins which are necessary to understand the companys financial performance and financial strength. For instance, when a company reports a high profit is an indicator that it will continue performing well in the foreseeable future. Such a company will have no issue meeting its debt obligations.

References

Delimatsis, P. (2013). Transparent Financial Innovation in a Post-Crisis Environment. Journal of International Economic Law, 16(1), 159-210.

Hunton, J. E., Libby, R., and Mazza, C. L. (2006). Financial Reporting Transparency and Earnings Management (Retracted). The Accounting Review, 81(1), 135-157.

Nimalathasan, B., & Brabete, V. (2010). Capital Structure and Its Impact on Profitability: A Study of Listed Manufacturing Companies in Sri Lanka. Young Economists Journal/Revisit Tinerilor Economist, 8(15).

Nizhneva, N., and Nizhneva-Ksenafontova, N. (2015). Financial Planning and Control in the Elt Context.

Saleem, Q., and Rehman, R. U. (2011). Impacts of Liquidity Ratios on Profitability. Interdisciplinary Journal of Research in Business, 1(7), 95-98.

Welch, I. (2011). Two Common Problems in Capital Structure Research: The FinancialDebttoAsset Ratio and Issuing Activity Versus Leverage Changes. International Review of Finance, 11(1), 1-17.

White, G. L., Sondh, A. C., and Fried, D. (2005). Analysis of Financial Statement. Analysis.