Before banks decide to grant you a loan, they take all of the financial aspects of a business, including its financial statements, into consideration. The balance sheets, income statements and cash flow statements are major documents to be reviewed by the bank because they are liable to safeguard their shareholders’ capital and comply with regulations. They also need to prepare for the worst as the borrower might go bankrupt, which makes recovery of the loan extremely difficult. Therefore, before extending credit, banks thoroughly go through the financial statements of individuals and businesses to ensure the repayment of a loan.
An income statement breaks down the sales and expenses of a company into all its components and also highlights the net profit. By carefully analyzing the income statement, banks try to figure out the expenses that go into making a certain product or service, including direct and indirect expenses. Before extending credit, financial experts, hired by banks, go through the income statements to find out if a firm invests in premium products with low volume or indulge in high volume sales at a discounted price. All of this information is necessary to determine if the business under scrutiny is sustainable over a long period of time or if it is just another hopeful venture that falls into oblivion, like many others.
Cash Flow Statement
For a banker, it’s valuable to assemble creditworthiness of data from balance sheets and income statements. However, the eventual goal is to measure the cash flows of the borrower. By reviewing liquidity arrangements, the bank ensures that the company has a steady influx of cash and that it is eligible for extending credit. A cash flow statement offers an understanding of a company’s liquidity movements in operating, investing and financing activities.
The flux of cash, whether in or out, can be because of past actions by the company. Therefore, cash flow is carefully analyzed by the bank. If there is any loan that was taken previously, it would show in the cash flow. Basically, the goal of the bank is to see if you have enough cash resources to run the business and pay off the loans at the same time. Banks actually like extending credit to clients that have a positive cash flow statement because, to run their business, they require people and businesses that are in need of a loan. So, it ultimately serves their own interest as well.
The balance sheet of a company shows what the company owns and what it owes in the form of liabilities. The assets of a company, which include land, machinery, cash, and other intangible assets, are analyzed to judge the worth of a business. Any loans and accounts payable fall under liabilities that need to be paid off by the company. Information about equity and stockholders is also included in the balance sheet and, before extending credit, banks go through that information to find the liable parties in case of a nonpayment. Also, the assets of the business are the first items to be disposed of by the bank if the business fails to repay the loan. A balance sheet offers a detailed description of a business and is the most vital source of information used by banks and other stakeholders.
Other Considerations Before Extending Credit
Most of the information about a company will come from these above statements. However, there are always some details that remain hidden from these reports and are sought after by the bank. For example, if a company has been involved in a lawsuit or any other judicial proceeding, the information will not be present in the statements. To tackle that, banks go through extensive research about the company operations and sometimes even conduct interviews with company’s management and employees to better understand the situation. In short, banks take all possible measures before extending credit to ensure its full repayment with interest.
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