Examine three different categories of people who read financial statements – financial analysts, creditors, and investors. Choose one category and provide examples of the types of information the person would be interested in. Explain why each type of information may be important to the person. Plus, describe the financial functions performed in an effective financial system.
A Creditor is primarily interested in the company's liquidity (short-term cash flow) and solvency (long-term ability to meet obligations).
| Information Type | Financial Statement Source | Why It's Important to a Creditor |
|---|---|---|
| Current Ratio (Liquidity) | Balance Sheet (Current Assets / Current Liabilities) | Measures the company's ability to cover its short-term debts using its short-term assets. A higher ratio ($>1.0$) indicates a lower risk of default in the near future. |
| Debt-to-Equity Ratio (Leverage/Solvency) | Balance Sheet (Total Debt / Total Equity) | Shows the proportion of financing that comes from debt versus equity. A high ratio indicates the company is highly leveraged, increasing the risk to the creditor if the company faces a downturn. |
| Interest Coverage Ratio (Profitability) | Income Statement (EBIT / Interest Expense) | Indicates the company's ability to pay the interest expense on its outstanding debt. Creditors want this ratio to be significantly higher than $1.0$ to ensure the company has a strong buffer to meet its interest payments. |
| Free Cash Flow | Statement of Cash Flows (Operating Cash Flow - Capital Expenditures) | Represents the cash the company has left after funding operations and necessary capital investments. This is the actual cash pool available for discretionary items, including debt repayment. |
An effective financial system, whether within a company or spanning the broader economy, performs several crucial functions to facilitate resource allocation and economic activity.
Mobilizing and Allocating Savings:
Function: Collecting idle funds (savings) from surplus units (savers) and channeling them to deficit units (borrowers or companies needing investment capital).
Importance: This transfers resources from those who don't need them immediately to those who can use them productively (e.g., funding new projects or R&D).
Risk Sharing and Management:
Function: Providing mechanisms (like insurance or diversified investment funds) that allow individuals and companies to transfer or pool risks.
Importance: By spreading risk, large-scale, high-return projects that would be too risky for a single entity become viable.
Financial statements are read by various groups, each with distinct needs. Three major categories are financial analysts, creditors, and investors.
Financial Analysts: These professionals work for investment firms, banks, or rating agencies. They study a company's financial health, performance, and prospects to make recommendations (e.g., "buy," "sell," or "hold" a stock) or to determine a credit rating.
Creditors (Lenders): This group includes commercial banks, suppliers offering trade credit, and bondholders. They are concerned with a company's ability to repay debt on time.
Investors (Shareholders): This includes current and prospective owners of the company's equity (stock). Their primary interest is the company's profitability and growth potential, which directly affects the value of their investment.
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