Financial statements offer creditors a comprehensive look at the financial health of a business. 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.
Simply put, current ratio is the current business assets divided by the current business liabilities. Current is defined as the coming 12 months. Assets include cash, receivables, inventory and prepaid expenses, while liabilities include accounts payable, credit cards and accrued expenses. A current ratio of more than 1.2 is generally accepted as a good ratio. Creditors use this ratio to determine the ability of a business to repay its debt over the next year.
Creditors use the debt-to-equity ratio to determine the relative proportion of shareholders' equity and debt used to finance a company's assets. 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.
Source of Loan Repayment
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.
Secondary Source of Loan Repayment
While cash flow is typically considered a primary source of loan repayment, it may not be sufficient to cover operating expenses and additional debt repayment. Estimating cash flow can also be difficult for start-up businesses or business expansion. Creditors utilize financial statements to determine secondary sources of loan repayment, also referred to as collateral, such as business-owned real estate, equipment, receivables or inventory. In the event a business is unable to repay its debt, the creditor may be able to liquidate these items to satisfy the debt.