Income statement of a service company and a merchandising company.

Sample Solution

The key distinction between the income statements of a service company and a merchandising company lies in how they account for revenue and cost of goods sold (COGS).

Service Company:

• Revenue: Service companies record revenue when the service is rendered to the customer.
• No COGS: Since service companies don't sell physical products, they don't have an expense category for COGS.
• Expenses: Service companies record expenses related to providing the service, such as salaries, rent, and utilities.

Merchandising Company:

• Revenue: Merchandising companies record revenue when they sell goods to customers.
• COGS: This is a crucial expense that represents the cost of the merchandise purchased for resale. It's subtracted from revenue to arrive at gross profit.
• Expenses: Similar to service companies, merchandising companies record expenses related to operating the business.

Critical Items for Creditors in a Merchandising Company's Income Statement:

1. Gross Profit: This line item shows the company's efficiency in purchasing and selling inventory. A high gross profit margin indicates the company is effectively managing its purchasing costs and selling prices. This is important to creditors because it reflects the company's ability to generate profit from its core business activity.

2. Inventory Turnover Ratio: This ratio (calculated by dividing the cost of goods sold by the average inventory) measures how efficiently the company sells its inventory. A high inventory turnover ratio suggests the company is managing its inventory well and not holding excessive stock, which could tie up cash flow. Creditors are interested in this ratio because it reflects the company's ability to manage its working capital effectively.

Full Answer Section

Rationale:

Creditors, such as banks or suppliers, rely on the income statement to assess a company's financial health and creditworthiness. The gross profit and inventory turnover ratio provide valuable insights for creditors because:

• Gross Profit: It indicates the company's ability to generate profit after accounting for the cost of acquiring inventory. A healthy gross profit margin suggests the company has a sustainable source of revenue to meet its financial obligations.
• Inventory Turnover Ratio: A high ratio suggests the company can efficiently convert inventory into cash, which improves its liquidity and ability to repay debts. A low ratio might indicate potential problems like excess inventory, which could lead to cash flow issues and difficulty meeting debt obligations.

By analyzing these items, creditors can make informed decisions about extending credit to a merchandising company.