Chapter 7Users of Financial Statements

Learning objective

  • Recognize the ratios creditors use to analyze a set of financial statements.

Introduction

In this section, we examine the different ways in which creditors and owners look at a set of financial statements. Creditors are more balance sheet oriented. Owners and managers are more income statement oriented.

Ratios examined by banks for short-term loans

Short-term creditors are primarily interested in the balance sheet, which shows the firm’s current financial condition. These six ratios are commonly used for this purpose:

  • Liquidity ratios such as the current ratio
  • Cash and equivalents plus trade receivables to current debt
  • Receivables to average day’s net sales
  • Inventory turnover or supply in days
  • Debt to (tangible) net worth
  • Net fixed assets to (tangible) net worth

Lenders and creditors are concerned with two things: the borrower’s ability to repay and the security in case the borrower cannot repay.

Given these facts, how does a creditor view financial information? The answer depends upon whether we are dealing with short-term or long-term debt.

Knowledge check

  1. When a company applies for a “short-term” bank loan, the ratios that the loan officer is most likely to base the loan decision on are
    1. Profit ratios.
    2. Liquidity ratios.
    3. Stock market ratios.
    4. All ratios.

Ratios examined by banks for long-term loans

The importance of the income statement increases with the length of the loan. Bankers place more emphasis ...

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