Income statement of a service company and a merchandising company.

Sample Solution

The income statements of service and merchandising companies differ in key ways due to the nature of their business activities. Here's a breakdown:

Service Company:

• Focuses on services: Revenue comes from performing services for clients.
• No Cost of Goods Sold (COGS): Since they don't sell physical products, there's no COGS section.
• Simpler format: The income statement primarily shows revenue, operating expenses, and net income.

Merchandising Company:

• Sells physical goods: Revenue comes from selling products purchased from suppliers.
• Includes COGS: This section reflects the cost of the goods sold during the period.
• More complex format: The income statement accounts for purchases, inventory changes, COGS, gross profit, operating expenses, and net income.

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

1. Gross Profit: This line item shows the profit earned after accounting for the cost of acquiring the goods sold. It indicates the company's efficiency in purchasing and managing inventory. A high gross profit margin suggests the company can generate a healthy profit even after covering the cost of goods.

Full Answer Section

1. Inventory Levels: Although not a specific line item, creditors use COGS and knowledge of the company's business cycle to estimate inventory levels. High or low inventory levels can impact a company's ability to meet future sales demands or indicate potential obsolescence issues.

Rationale:

Creditors are primarily concerned with a company's ability to repay its debts. The income statement provides insights into a company's profitability and operational efficiency.

• Gross profit reflects the company's markup on products and its capacity to generate profit after accounting for the direct cost of goods. A strong gross profit margin indicates a higher potential for generating cash flow to service debts.

• Inventory levels influence a company's cash flow. Excessive inventory can tie up cash, while insufficient inventory could lead to lost sales opportunities. Creditors use this information to assess the company's liquidity and potential risk of defaulting on loans.

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