Accounting information about a business is not just relevant to its owners and managers. Other users of accounting such as the creditors also require accounting information about a business.
Creditors need accounting information about a business to help them in their lending decisions.
Creditors assess the financial stability of a business from its financial statements. This information is required to ensure that a borrower is capable of paying back the loan to its creditor.
Creditors include anyone that lends money, goods, or services to the reporting business on credit.
When issuing a loan, or supplying a product or service on credit terms, there is a risk that the borrower may fail to pay back the full amount of its debt to the creditor because of bankruptcy.
To reduce the likelihood of a bad loan, creditors perform a credit risk assessment based on the financial information of a potential borrower.
What do creditors look for in financial statements?
Creditors are interested in the financial statements of businesses to learn about the status of their going concern, profitability, financing, liquidity, and cash flow.
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 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?
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.
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.
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?
How do creditors assess creditworthiness
Creditors assess the creditworthiness of potential borrowers by evaluating their historical and prospective financial information.
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?
Creditors use accounting information of businesses to reduce their credit risk (i.e., the risk of a borrower defaulting on loan repayment).
Creditors often use a scoring system to rate the potential risk of the borrower. For example, a borrower with a poor credit history will get a lower credit score than someone who has a record of making timely loan repayments in the past.
The risk profile of a borrower impacts the terms of credit offered by a creditor. Of course, if the risk is too high, the creditor may decline a loan to a borrower.
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.
- Not to sell the assets held as collateral without the permission of creditor.
- Not to borrow loans beyond a specific limit.
- Repay the entire loan immediately if certain circumstances arise.
- Review of borrower’s financial statements and credit history after regular intervals throughout the loan period.