Use of Profit and Loss Account, Balance Sheet, and Cash Flow Statement - Coursework Example

Accounting Introduction The surplus funds of a company are proposed to be invested as a loan to a restaurant that has submitted the recent financial statements along with the application of loan. Under such a scenario a report has been prepared that provides an explanation about the importance and uses of profit and loss account, balance sheet, and cash flow statement (the other financial statement) from the point of view of lender. The report also contains a list of further information and documents required before taking a lending decision; and it also assesses the relevance of financial statements submitted with loan application with regard to recommending lending the surplus funds to restaurant. Contents Introduction Contents Importance and uses Profit and Loss Account Importance and uses of Balance Sheet Importance and uses of Cash Flow Statement Requirements of additional documents and information Relevance of financial statements of restaurant Recommendations References Importance and uses of Profit and Loss Account Profit and Loss Account is an important financial statement from the lenders point of view in order to arrive at a lending decision. This financial statement evaluates the operational and other activities of an entity over a fiscal period, though it may drawn for any period of business activities say for month, quarter, half year, or for a year. Profit and loss account contains information about revenue (or sales), costs of sales, beginning and ending inventories, operational expenses details, interest and other financial expenses, and information about taxes as well. A comparative analysis of revenue or sales from previous few years of profit and loss accounts will provide the marketability trends of product being dealt in. In case of a restaurant revenue will be from sale of eatables and drinks. If sales are continuously rising there is every possibility that fresh loan when invested into the business will bring more revenue to generate extra profits. Cost of sales provides an idea about the nature of expenditure involved that directly fluctuate with sales and their effect on profitability. If for example loaned funds are used for purchasing kitchen equipments of the restaurant, then depreciation on machinery being manufacturing cost will enhance the costs of sales and thus reduce the margins if expected increase in revenue is not generated. That is why a ratio generated by profit and loss account called ‘Gross Profit Margin’ has gained importance in analyzing the results particularly during inflationary period. “The gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its good.” (Lawrence J. Gitman, page 67)1 The expenditure recorded in profit and loss account after calculating the gross profits are called below the line expenses and help in computing operating and net profits. Mostly these are overheads and the lender can have an idea about fixed and variable nature of overheads like rent of the restaurant, insurance expenses are fixed and have to borne out even whatever the level of sales or profits etc. The most important aspect is the assessment of finance expenses like interest on already loaned funds. The lender can find out whether the business will be able to bear the burden of additional interest. This can be done by calculating Times Interest Earned ratio that measures the ability of the business to meet contractual interest expenditure. Finally net profits show the trend of profitability after meeting tax expenses that helps the lender in determining whether extra profits will be generated at least to meet out additional liabilities by taking fresh loans. Importance and Uses of Balance Sheet Balance sheet is a financial statement that presents the financial position of an entity on a particular date. “The balance sheet has two sections. The first section shows the assets. The second section shows the liabilities (or debts) and owner’s equity, which together represent the claims against the assets. The total assets always equal the combined totals of liabilities and owner’s equity (or capital) – that is why this financial statement is called a balance sheet.” (Ronald C Spurga, page 7)2 Lender’s interest in balance sheet is primarily is to judge how the total assets of the restaurant has been financed, that is to say the financial leverage of the business. If loan funds are used more than owned funds then the business will have more of fixed nature liabilities and this may create problems in deflationary periods. The lender is again interested in solvency of the business and that depends upon the current assets and current liabilities of the business at any particular time. Current assets are those that are converted into cash within one year or within one accounting cycle, whichever is longer. Common examples of current assets are cash, accounts receivable, investment in trading securities, inventories, and prepaid expenses. A liability that will be settled within one year or one accounting cycle, whichever is longer, is considered current liability. In addition, a liability that will require the use of current assets is current liability. Common examples of current liabilities include accounts payable, accrued expenses, dividend payable, current portion of long term debts, and others. Current ratio calculated from current assets and liabilities will provide the solvency status, and the lender will come to know whether the business will be able to meet interest obligations of fresh loan. Importance and uses of Cash Flow Statement Cash flow statement provides information about inflows and outflows of cash and cash equivalents. Inflows and outflows of cash and cash equivalent are reported in three categories, namely, cash flow from operating activities, investing activities, and financing activities. Lender is interested in the payment of interest dues and repayment of principal loan at maturity. Interest is part of operating activities activities, and existing cash flow statement will give an idea of present situation of surpluses or deficit from operations of the business. If the entity is presently generating operational cash flow deficit, then the lender will have to think twice before lending funds to the entity. Net cash flow from financing activities is important as these activities include transactions involving debts and owners equity. Projected cash flow statement will provide an idea about net surplus or deficit at the time of maturity of loan being given the restaurant. It may be noted that interest payments are considered outflows from operating activities and not financing activities. Therefore cash flow statement will help lenders in taking a decision when there are regular surpluses from operating and financing activities. Requirements of additional documents and information In order to consider the proposal of loan to the restaurant, the following additional documents and information will be required by the company besides the attached financial statements: Projected financial statements for coming few years after taking loan in order to analyze those from the point of view of meeting the liabilities of interest and repayment of loan at maturity. Rent or lease agreement to assess the remaining period the business of restaurant can run from existing premises. Present loan agreements, if any and a certification from present lenders about their no object to fresh loans. Documents relating to security, and if the security provided is a property then some evidence showing that such property is free from all encumbrances. Copies of banks statements showing the regularity of bank transaction as this will help in counter checking of revenue and expenses shown in the profit and loss account. Relevance of financial statements of restaurant The restaurant seeking loan from the company has already attached its earlier financial statements with application for the loan. The analysis of these financial statements will play crucial role in decision making by the company. The company is interested in two basic criteria about restaurant before taking a decision about lending. First is the present and future earning capacity of the restaurant; and second the debt servicing status of the restaurant during the tenure and at the maturity of loan. In this process the company should assess the financial statements ratio analysis, as “ratio analysis is useful in assessing the credit impact of a major transaction.”(Martin S. Fridson and Fernando Alvarez, page 307)3 The financial statements submitted with the application, when analyzed, will reveal the existing potentials of the restaurant to earn profits. The calculations of gross profit and net profit ratios will provide a profitability trend on the revenue so far yielded by the restaurant. This will give an idea about earning potentials of the existing business. Calculations of its inventory turnover will provide how many times the inventory is rotated in a period to yield revenue. Similarly the assets turnover ratio will provide how the assets are used to generate more sales in the restaurant. It may be possible that restaurant might be suffering from liquidity problems and that is why seeking further loans. Current ratio and quick ratio will provide an idea about the short term solvency position of the restaurant. That is to say, whether the restaurant is in a position to meet its short term obligations when those become due. Cash flow statement if submitted along with other financial statements will reveal the surplus or deficiency on account of operational, investing, and financing activities of the restaurant business during the pervious period. Accordingly the areas where the fresh loans will be utilized will be revealed from existing position of cash flow statement. Debt ratio calculated on basis of loaned and owned funds invested in the restaurant will reveal the financial leverage of the business in order to determine the existing fixed interest liabilities. The management of the company can also calculate ‘time –interest- earned’ ratio in order to find out how many times existing earning before interest and tax (EBIT) covers the fixed interest liabilities. The company should also seek projected financial statements including cash flow statements in order to find out the projected debt service ratio of the restaurant in order to judge the safety of interest dues and the principal loan at respective maturities. Recommendations The decision to extend loan to restaurant will depend upon two factors. The first is the increase in profit generating capacity after providing loan as measured on the basis of projected inventory and asset turnover ratios linked with exiting profitability ratios. Second factor is availability of liquidity at the time of debt services, which is provided through projected debt service ratio of the restaurant. The company should extend loan to the restaurant only when both these parameters are positive. Conclusion Lending decisions involves analysis of existing financial statements of the borrower alongside projected financial statements in order to find out the projected effects on earning capacity and repayment capacity of the borrower. When it is evident from such analysis and also from the investigation of other factors and information that business of borrower will remain a going concern that can easily service the costs and principal repayments of loans, then only lender should decide in favor of lending. Otherwise lender should shy away from the proposal. References Read More