One of Natalie's friends, Curtis Lesperance, runs a coffee shop where he sells specialty coffees and prepares and sells muffins and cookies. He is eager to buy one of Natalie's fine European mixers, which would enable him to make larger batches of muffins and cookies. However, Curtis cannot afford to pay for the mixer for at least 30 days. He asks Natalie if she would be willing to sell him the mixer on credit.

 

Question:

Curtis has given me a set of his most recent financial statements. What calculations should I do with the data from these statements, and what questions should I ask him after I have analyzed the statements? How will this information help me decide if I should extend credit to Curtis?

 

Answer:

1. What calculations should I do with the data from these statements, and what questions should I ask him after I have analyzed the statements?

Compute for Profitability, Solvency and Liquidity Ratios and ask him these following questions:

• Is he willing to pay in less than a year?
• Does he have any plans of getting more services, assets or cash from other creditors?
• What are the odds of making his coffee shop unprofitable?

2. How will this information help me decide if I should extend credit to Curtis?

Lenders and creditors are one of the users of financial statements. This information is very valuable and beneficial to them. Financial Statements can give  lenders and creditors a comprehensive look and analysis about the financial health of the company. As what being said above, details such as income, current debt obligations, expenses, inflows and outflows of the company can be seen on the statements. Comparing the current obligations or debt to current assets will help Natalie decide if she will allow Curtis to get the coffee mixer on account. A promise to pay is just a merely promise without knowing the financial status of the company.

After getting the financial statements, you now have the chance to compute for ratios and analyze company's performance in the industry. There are several number of ratios you need to consider that would really help you (as creditor) on making the decision. First, Profitability Ratio it is composed of three sub ratios namely Net Profit Margin (NPM), Return on Equity (ROE) and Return on Investment (ROI), as what the name implies (profitability), it is the ability of the company to earn an amount that could help the company sustain its position. Second, Solvency Ratio it is used to measure the ability of the company to pay its long-term debt. It is used by big business lenders and has two sub ratios namely Debt to Equity Ratio (DER) and Debt to Asset Ratio (DAR). Lastly, the most important ratios that Natalie have to consider, Liquidity Ratio. It is composed of three ratios namely, Current Ratio, Quick Ratio and Ratio Cash. The importance of Liquidity Ratio is to show you whether the company is liquid enough to pay its short-term debt. The basis of computations under this ratio is all about the current assets and current liabilities. Short-term debt is one year or less and long-term debt is above one year.

• Is he willing to pay in less than a year?

This would really help Natalie on how she account the receivable. Less than a year means it will fall on current asset (accounts receivable) and if it will take Curtis more than a year, then Natalie will classify the receivable as non-current asset. Aside from recording purposes, it will also help with regards to expected inflow of the company.

• Does he have any plans of getting more services, assets or cash from other creditors?

Additional creditors can impair the ability of Curtis to pay its debt. Growing number of creditors means more cash and asset to Curtis' books, but equally more liabilities. Knowing his intention to seek for more creditors will help Natalie decide if Curtis can fulfill his promise.

• What are the odds of making his coffee shop unprofitable?

Knowing all the factors and chances on what makes the coffee shop unprofitable will be a good question from Natalie. Businesses not only rely on its internal operations. Some economic and external factors can affect the inflows of the company. Determining the weakness of the shop will help Natalie evaluate the terms.