TRADE CREDIT AND COLLECTION assuming by the latter of a risk or probability

MANAGEMENT of fulfillment of the commitment. In a credit

By E.H. Ocampo transaction, one offers his commitment,
Instructor: NORA BIEN-CAPISTRANO backed by his character, capacity, and
1.THE VALUE OF CREDIT TO YOUR capital, whichthe other, following his
BUSINESS evaluation, may accept or reject. An
A. Some Perception of Credit exchange of value takes place when there
Many interpret credit as one of two things, exists a mutual trust. When this is multiplied
depending on one's point of view. several folds in a given market, the
Commonly, credit is something owed on an economy becomes active and energized.
account; it is the converse of debit, if viewed
from the side of an accountant. When a B. Credit as A Marketing Tool
lawyer is asked, we would define it as an The majority of firms sell their products or
act, i.e., credit is a legal right of the creditor services on credit. Department stores with
to demand and receive payment in hundreds of product lines to sell are retailing
exchange for something of value. to consumers on credit, running from 15 to
To the marketing and economic viewpoints, 60 days. They make use of in-house as well
credit is perceived as a form of purchasing as bank credit cards to bolster sales. Avon,
power. As such, it constitutes an element of MSE, Natasha, Boardwalk are being used
demand, comprised of the willingness and by individuals, usually employees of
the ability to buy a product or service. As a business offices and factories who settle
type of purchasing power, credit is a vital their accumulated purchases every payday
factor by the expansion of which the in regular small amounts. The dealer
economy is stimulated and energized, in collects and remit to companies on a 30 day
contrast, the economy would recede in or more intervals. Restaurant operators also
activity when credit is contracted.This is so find it necessary to service a customer on a
because the prospective buyer's ability to 30-day credit, usually through bank credit
acquire goods or services now in exchange cards and personal open credit accounts.
for a commitment to pay later will be limited. Credit is also regularly extended by
From our viewpoint, we shall look at credit merchandise producers to wholesalers who
as a marketing function, which unescapably in turn sell on charge account to retailers,
will involve it both as an act for a creditor or and so on. A distinctive attribute of trade
seller and as an economic power for a credit or business credit as some call it is
buyer or debtor. We shall then define credit that it helps to move products from the
as the ability of a purchaser(user) of an source of supply to various marketing
economic good (commodity or service) to channels and ultimately end with the
acquire it presently in exchange for his consumers.
commitment to pay for it at an agreed future Individual retail, service, wholesale and
date. Two elements are present: futurity and production firms that credit accounts tend to
risk. Something of value will be acquired build a clientele or regular customers who
now by one party- the purchaser or concentrate their purchasing with those
user-and his commitment to pay back the firms where they have accounts. It has been
other part- the seller or the owner of the noted that credit customers buy more
thing of value -in the future, which involves merchandise than do cash purchasers. A
credit customer tends to buy from three to Eventually such transactions will result in
four times as much as a cash purchaser. cash changing hands, but in the meantime,
Properly handled, credit transactions tend to we cannot ignore the If a business grants
create a closer relationship between the trade credit to its resource commitment.
customer and the selling firm. This gives customers, for example, its own funds or
rise to greater sales volume, not only with resources are in effect used by someone
the individual customer but through else until repayment. If a business obtains
word-of-mouth publicity by a loyal, satisfied trade credit from a supplier, someone else's
clientele. funds or resources will in effect be
Credit has become an important competitive employed in the company until repayment is
factor in modern business. In most lines made.
merchandising, the customer has come to The concept of working capital may be
expect credit as a matter of course. graphically perceived in the illustration:
Businessmen today must keep abreast of
competitors who are offering credit facilities. ILLUSTRATION 2- The Working Capital
CycleCash
ILLUSTRATION 1 - What Products Credit As shown in the illustration, working capital
Move starts with cash which may be funded
A huge quantity and wide variety are bought internally by management or externally by
on the installment paying basis. This making use of trade supplier via application
includes hard or durable items such as of credit. Thus, part of the stock inventory
computers/gadgets, refrigerators, musical will be directly owned by the company and
instruments, furniture, and stoves, soft or another part owed to trade creditors thereby
perishable goods such as clothing, blankets creating an obligation in the form of
and sporting goods, even house/house & lot accounts payable. With stock available, the
or office building. company can cause sales to be made
C. Credit as A Tool in Working Capital through its distribution channels. In a very
Management simple business operation, cash sales are
What is working capital? Ordinarily, we think possible, however, in more complicated
of working capital as cash since cash is the businesses, such as manufacturing and
easiest form of expressing economic value marketing operations, a major portion (up to
and is readily convertible into goods and 90%) of sales is done on credit basis,
services. A business operation normally creating therefore a resource deployment in
involves a great number of cash the form of accounts The receivable which
transactions over a period of time, as wages require time to collect before becoming
are paid, machinery and stock inventory cash. subsequent cash revenues are then
acquired, products advertised and sold, utilized to repay the company's liabilities
revenues collected, etc. (accounts payable, loans, wages, taxes,
Not all resources, however, are obtained or etc.); any leftover is recycled back into the
committed on the basis of cash business.
transactions. Management has the D. Relationship Between Sales Growth and
discretion to grant or obtain credit, and Current AssetsThe relationship between
every time this discretion is exercised an sales growth and the need to finance
economic resource has been deployed. current assets (mainly cash, accounts
receivable, stock inventories, and some obligations while awaiting sales revenues
highly marketable securities/notes) is close represent another example of prudent use
and direct. For example, if the firm's of credit.
average collection period is 40 days and if Credit is not always used widely by the
its credit sales are P1,000 a day, the ultimate consumers, nor by large
investment in accounts receivable will be commercial or industrial business firms.
40,000. If sales grow to 2,000 a day, the Many consumers find themselves living in
investment in accounts receivable will rise extravagance while some firms overextend
to 80,000. Sales increases produce similar themselves when the credit conditions
immediate needs for additional inventories become tight, they fail to honor their
and perhaps for cash balances. All such commitments.
needs must be financed, and since they Credit has been much abused by creditors
arise so quickly, it is imperative that the themselves. Owing to their laxity and
credit manager and the financial manager of carelessness in credit extensions, creditors
the firm keep themselves aware of may cause speculation and overtrading
developments in the working capital which sometimes lead to fraud and
segment of the company's operations. Of embezzlement.
course, continued sales increases will The national government is no exception
require additional long-term assets, such as either. One needs only to recall the years
more machineries, equipment and even 1981 through 1986 when the Central Bank
plant structures, which must also be did not have enough dollar resources to
financed. However, fixed asset investments, repay the matured and term debts due to
while critically important to the firm in a foreign creditors from whom the government
strategic long-run sense, do not generally obtained through the years some US$28
have the same urgency as do current asset billion in loans. Unfortunately, the bulk of
investments. such foreign loans went wasted to" invisible"
E. Credit and Commercial Failures expenditures leaving the burden of repaying
The prudent use or mismanagement of the billion-dollar indebted ness to the tax
credit can spell the difference between the payers - poor Juan de la Cruz of the
success or failure of any business. Philippines.
Many business failures are the direct result F. Credit and The Business Cycle
of improper credit practices and are Few would deny that credit is a strong
independent of the general condition of contributing factor in the oscillating
business. Credit when used constructively movement of business. Wesley C. Mitchell
can boost the progress of business. A firm has viewed the business cycle as a
that borrows a working capital loan from a wave-like pattern, consisting of four (4)
bank and applies the cash proceeds to tide distinct phases:
over its operations until the accounts 1) Revival or recovery. when business
receivable is collected and its loan repaid is activity begins to activate from dullness.
a fine example of constructive use of credit. 2)Expansion: when the activity in business
Industrial buyers who utilize credit for shows progress and begins to peak.
purchases of raw materials and supplies 3) Recession: when business is at its peak
and in borrowing from banks and other of activity shows signs of declining in
financial institutions to meet its recurring growth.
4) Contraction or depression. the level at instability, loss of business confidence,
which business activity comes to inactivity, unabated inflation, unemployment, and
characterized by many bankruptcies, closed breakdown in the peace and order situation.
shops, unemployment and fallen prices, etc. II.PROFESSIONALISM IN CREDIT
Explanations of the causes of business MANAGEMENT
cycle are varied such as: maladjustments A. The Need for Skill in Credit Management
between income and prices: Managed skillfully and intelligently, credit is
maladjustments between the production of a productive of much individual and social
consumers; goods and the production of good. The abuse of it, however, is
industrial materials; overproduction; and the dangerous. Unwise credit management
volume end cost of credit available at the tends to undermine the entire structure
different stages of the business cycle. upon which business is founded, for it not
On a rising market everybody feels only deal a crushing blow to the credit
confident, optimism is the prevailing grantor, but also work hardship on his
keynote, large profits are earned by all, still customers and, in the end, tend to shake
larger profits are anticipated, and the confidence so generally prevailing in
investments in plant and machinery are one's business relationships.
increased accordingly. Value of property Knowledge of credit principles is required
rise, and this makes them readily today not alone by those who are extending
acceptable as collaterals for loan, hence credit, but by businessmen in general, for
expansion of credit. So long as the upon them, too rest attitudes and decisions
confidence in anticipated higher earnings which no businessman can wholly escape.
lasts, so also will the upward movement of Not merely how, to extend credit, but
the process continue. Finally, the bottom whether to extend it and what responsibility
drops out and the process undermines must be assumed by credit grantors and
itself. As anticipated margins of profit are recipients alike-these are some of the
not realized, prices begin to tumble. questions which require the appraisal of the
Pessimism replaces optimism, credit for the credit function as not a technicality not as a
most commendable borrower is refused, major economic force.
collateral shrinks in value, loans are called Credit is a necessity and not a privilege
in, and collections are made closer, but granted to the purchaser of goods by the
repayment slowdown. Deflated prices graciousness and generosity of the seller.
enhance the difficulty in meeting obligations, Extending credit is not benevolence but
and liquidation of businesses follows. The business. It enables a business firm to
Philippines' experience in 1973-74 when a adjust the volume of capital.
business recovery was observed; 1975-78, To the varying needs of business. It is,
recessionary conditions in the USA and therefore, the more important that credit be
Japan affected the Philippines; 1979-83 managed well, that is advantages may
recession in the country deepened as enjoy not to the few, but to the many whom
aftermath of the spiraling prices of crude oil; it is capable of serving.
and immediately after through 1986, the
worst conditions of business contraction B. Qualities of A Professional Credit
was felt, not only owing to the general world Manager
business slowdown, but also due to political
The professional status of the credit should be thoroughly investigated and
manager today continues to gain wider decisions based upon an accurate
acceptance and the true role of his function knowledge of facts. To be through does not
is more clearly anticipated. necessarily mean going into great detail. It
Mental skill is an outstanding characteristic does mean, however, that a task must be so
of a good credit manager. The development performed as rightly to deserve the
of this skill requires preliminary attainment designation of completeness.
of knowledge and the development of that Even Temperament. A good credit manager
knowledge through further training and must not be affected from day to day by
experience. This development must be personal feelings and mental attitude.
broad, for scientific credit granting is Evenness of temper and coolness of
increasingly predicated upon general judgment are two indispensable requisites
economic factors. in the profession under consideration. He
A sense of public function and responsibility cannot afford to be pessimist one day and
must be imbued in the credit manager, for an optimist the next.
the influence of his decisions extends not Firmness. He will often be criticized and
only to his institution and its immediate prevailed upon by the salesmen, sales
customers, but to competition and manager, customers, and others, but should
community as a whole. The nevertheless adhere to his conclusions
Accomplishment of social objectives is unless additional facts are presented which
distinctly a professional end. would tend to modify the original decision.
Executive ability must be present in the Quickness of Decision. A credit manager
credit manager. In many instances the must be resourceful, quickly appraise given
position of credit manager tends equally conditions, and effectively handle them.
with that of other functional executives, such Foresight. The ability to foresee pending
as advertising manager, production economic conditions is an invaluable asset
manager, office manager, and personnel to the credit manager, for upon this vision
director. The credit manager, assume depends his evaluation of current risks.
responsibility for that portion of overall Hindsight. An able credit manager must be
business policy which involves the use of able to draw lessons from past experiences,
credit both in buying and selling. He not only his own but also from those of
coordinates his work with other executives others. A seasoned professional credit man
of the business organization and is is one who regularly updates his knowledge
responsible to top management for his and work techniques by learning how others
performance. in the field have encountered and solved
In brief, the essential personnel qualities of problems in credit, developed innovations in
a credit manager are - credit delivery systems and control
Adaptability. A credit man is not born and is methods. Experience, no doubt, still
not so much the result of inheritance as he remains to be the best teacher.
is a product of training. To succeed in his C. Functions of The Credit Manager
work, a credit manager must have a love for There are two very important objectives for
it. the credit manager, these are:
Thoroughness. A successful credit manager 1) To maximize credit sales, and
does not jump to hasty conclusions. Risks
2) To minimize losses from delinquent Towards the of goal of minimizing losses
debts. from debts, there should be a continuous
To accomplish the two principal objectives, review of the trade accounts receivable
the credit manager is called upon to portfolio of the company by the heads of
coordinate closely with his firms marketing marketing and credit. It is reasonable to
department in developing sales promotion expect that through the dialogue and
programs and strategies in promoting sales, exchange of ideas and information,
not only in cash basis, but also on credit especially on critical accounts, many
terms. The knowledge of credit manager irritants and misunderstanding could be
cannot be considered an asset until it is put resolved, thus paving the way for the
into circulation and shared with others in the achievement of corporate goals.
business organization. Finally, as representatives of the whole
The working relationship between the credit corporate organization, both marketing and
man and the marketing should be the full credit personnel must be ambassadors of
realization of the function of each goodwill to its customers. Relationship with
department and a complete and the customers must be governed by the
sympathetic realization of the difficulties highest ethical business standards and
under which the other labors. Both should long-range perspectives. The credibility of
understand that risk is inherent in all credit the supplier, through its marketing and
transactions, that possible growth can only credit representatives must be established
be achieved by taking calculated risk. The and preserved. This can only be attained if
risky transaction which is to be avoided is the two functions maintain a well-
not the one which has some element of risk, coordinated and balanced role in the
but the one which has an abnormal and performance of their respective functions.
dangerous amount of it. The credit manager Credit people must be business-getters and
must possess the expertise and experience in the same manner, marketing
to determine the degree of risk he can representatives are expected to assist in the
assume and for those which he cannot, he collection efforts.
must be able to communicate convincingly D. The Credit Management as A Profit
and necessarily supported by facts to the Center
marketing manager. No longer is the credit department today
While credit policies and conditions may be regarded as a cost center of an enterprise,
formulated, these should be treated only as rather it now enjoys the treatment as a profit
guidelines which could be deviated from In center. It has been asked whether the
other words, there should be under promotion of credit is worthwhile. In those
justifiable circumstances. degree of businesses where credit can be extended,
flexibility in the implementation of policies the answer definitely is yes. There are good
when dictated by changes in market reasons why effort should be made to
conditions, such deviation being agreed increase credit volume.
upon by both the credit manager and sales Charge accounts have made buying more
manager where such a course of action or convenient for customers. Surveys show
decision is envisioned to promote or sustain that credit customers buy better
the business of the enterprise. merchandise, are more price conscious,
and buy more goods than do cash
customers. The convenience of paying once rates rise and loans become harder to get,
a month, of being able to buy when impulse customers are tempted to seek financing by
or necessity rather than funds dictates, of simply paying bills less promptly. Prompt
being able to take advantage of attractive collection of receivables will make a firm be
offers, more than exceeds any convenience. less dependent on external financing thus
A credit customer offers the seller greater saving for itself borrowing cost, ergo,
possibilities. A closer relationship is improve its sales turnover to boost profit.
established between customer and seller, The other area is accounts payable.
cemented by the very nature of the credit Keeping current on one's accounts payable
privilege. Patronage takes on the form of is essential to retaining good credit status
habit, and the customer tends to record the and an unblemished trade reputation. Sharp
store somewhat as a shopping home. It is managers are becoming more "cash
looked upon as "her" store. As a result, the conscious", a keener eye on debts,
credit customers are opted to become collections and inventories. Many are
boosters for the store. postponing payments on selected accounts
In brief, the goals of credit operation should when, and to the extent deemed practical.
include: Setting priorities is a must when such a
(1) An increase in volume of sales point is reached. Determination should be
(2) A larger number of credit customers made as to who must be paid first to keep
(3) More business from present customers things running, followed by primary
(4) A larger carrying charge income suppliers and so on. If a company pay in
(5) Lower operating costs advance and gain a cash discount, rather
(6) Lower bad debt losses than buying on credit, the company will be
By establishing and then administering a left with more money to spend or invest.
sound credit policy, a business can achieve E. The Credit Department in the Business
the above goals of a credit operation. Organization The organizational chart
There are two major areas in working shown below are example of placement of
capital management where the credit the credit department in the business
department could be effective as a profit organization.
center. The first area concerns account
receivable. One should ask whether the
company through its sales people, ever
surrenders to the temptation to make a sale
to a known credit risk - just for the sake of a
sale. A surgeon general's warning is not
needed to realize how injury can be done to
the firms' financial health. It depends upon
the credit manager that his department has
a collection procedure that recognizes that
accounts receivable/collections are the
mainstay of a healthy cash flow.
It should be borne in mind that present
economic conditions require closer, than
usual policy of receivables. As the interest
 a thorough investigation and evaluation of
evidence made available to the lender.
2) Capacity, refers to a borrower's ability to
obtain the means of payment when his
obligation becomes due. The importance of
this factor is evident, for however desirous a
debtor is of paying, if he lacks the ability to
pay, he is as surely a poor credit risk as
though he were in want of willingness to do
so. Capacity is determinable by analyzing a
borrowers' financial statement, referrals to
known associates as well as personal
interviews and ocular inspection of his
business premises.
3) Capital, is the financial strength of the
risk, consisting of the amount and quality of
III.CREDIT RISK AND ITS EVALUATION assets expressed in money terms, which an
Credit Risk is an inherent element present individual or firms possesses in excess of
in every credit transaction. It arises from the what it owns. Accountants call it the net
personal circumstances of the debtor, be it a worth of the borrower. Capital can be
person or a business entity, which prevent determined out of the balance sheet of a
the payment of a debt obligation when due. credit applicant.
The risky transaction is the one which 4) Conditions, may be perceived as the
creditor want to avoid, for they would spare general business environment or
themselves the losses and complications circumstances prevailing at the time a credit
often resulting therefrom. Since credit request is being made. The merit of an
involves risk, it is not one which has any opportunity to extend credit depends upon
element of risk, but the one which has an the prevailing and prospective conditions,
abnormal and dangerous amount of risk that and these for the most part is beyond the
should be avoided. immediate affairs of the individual or firm.
A. The Yardstick of Credit General business conditions are one of the
The principal factors to be taken into factors which color the appearance of a
account into account in deciding whether or credit risk at any given time.
not credit should be extended, in what In business practice each of the C's of credit
amounts, and on what terms, are the four is given a different emphasis in evaluation,
C's: although theoretically, each has an equal
1). Character, represented by the aggregate importance in being indigenous to the credit
of distinctive mental and moral qualities risk.
belonging to an individual borrower. signifies
an active sense of what is right and wrong. B. A Credit Equation
Moral qualities include trustworthiness, Attempts has been made to express the
fairness, responsibility, industry, among factors in the credit risk in the form of an
others. Characters may be determined after equation, in order that risk evaluation might
be reduced to a mathematical basis.
Unfortunately, the inevitable personal applicant, but to be useful these must be
element in all credit risk prevents traits from reliable and complete. The income
being handled as mere quantum, thus the statement reflects managements' ability to
ultimate decision to grant credit must be one generate in excess of expenses over a time
of judgment and not of simple computation. period. The balance sheet represents the
As a guide, however, the following credit general financial condition of a
equations might be found useful, assuming firm/individual at a given point and indicates
a normal transaction under normal the liquidity of the business and the
economic and business conditions: protection which is available to creditor. A
Character + Capacity + Capital = Safety in third financial report in the form of a
Credit Limit cashflow schedule relates not only to the
Character + Capacity + Insufficient Capital = present but also to the immediate future.
Fair Credit Risk Based on in-depth analysis of the financial
Capacity + Capital + Impaired Character = statements, the financial risk is measurable.
Doubtful Credit Risk The third factor consists of four elements:
Capacity Character - Capital = Fraudulent general economic conditions, conditions
Credit Risk within the specific industry, the line of
Ordinarily, Certain values are assigned to business, and the time element. Lenders
the credit factors, such as 35% for like to have a long -range viewpoint and
character, capacity 30%, capital 20%, and devote much time to a continuing appraisal
conditions 15%, making a total of 100%. of business conditions. This results in a
C. Evaluating Credit general feeling of confidence or concern,
The basic problem of evaluating credit is depending on the circumstances and it
judging the degree of risk in a particular certainly influences the creditor's attitude in
customer and whether it is one which appraising requests for credit.
should be accepted. Conditions within specific industry also have
Three (3) elements are involved in the a bearing on credit analysis. If the
evaluation, namely: conditions in the industry coincides with
(1) The management general economic conditions, the industry
(2) The financial factor bey be strong or weak; if industry conditions
(3) The economic factor are running counter to general economic
Confidence in the key management of a conditions, the extension of credit will be
borrowing firm is all importance because the affected accordingly.
lender holds in his hands the means of The line of business which is basic to the
aiding management in accomplishing its well-being of the economy will receive the
business objective, or, the means of positive attention and every effort will be
defeating it. The character and ability of made to meet its requirement.
management are two very important The fourth element is time. Normally the risk
aspects. Even though ability (capacity) is in credit is related in part to time. If credit is
necessary, integrity and desire to meet to run for 30 days, the risk may be small
commitment even under adverse condition while if it is for over a year, it will
are vital to sound credit decision. undoubtedly be much greater.
The financial factor is measured by the Many prospective borrowers have the belief
financial statements submitted by a credit that if sufficient security (loan collateral) is
offered, the lender ought to make a loan g) Known business associates
without further question. More than the Direct interview with the borrowing applicant
security, the willingness, the ability, and the can yield many essential information and
means of repaying the credit obligation by insights about the nature of borrowing
the debtors must be evident. Basically, the request, repayment means, business
lender wants to get his money back after it operations, management background,
has served the purpose for which it was financial condition, credit references,
borrowed. He wants to get this back from industry profile, and even about the mental
the normal operations of the business. attitude and general personality of the
Depicted below is the process of credit borrower. Personal interview can become
evaluation, which is self - explanatory. highly revealing that often times a decision
to pursue the borrowing request is made on
the spot. It is vital, however, that the person
conducting the personal interview be
competent and give every appearance of
being familiar with human nature and the
policies of the house regarding credit
matters. It is not unusual for credit
dispensers to adopt a special credit
application form which is filled up by the
interviewer and or the applicant. The form
itself serves as part of the credit file.
References provided by the credit applicant
serve as initial lead for further verification
and evaluation by the creditor firm. Included
here are the applicant's past and present
credit relationships with banks, financing
companies, suppliers of goods and
D. Sources and Types of Credit Information services, as well as individuals (normally 3
The extension of credit facility, regardless of names and addresses) and trade
category, requires the presence of a affiliations.
reasonable amount of information on which Credit information bureaus undoubtedly can
evaluation and decision could be made. provide important information about specific
Commercial forms, similar to lending subjects of query. Credit bureaus are
institutions (banks, finance companies, organized primarily for the exchange of
investment houses, etc.) make use of the ledger information among associated
following sources of information: creditors. They have an established system
a) Direct personal interview with applicants whereby those who are interested in any
for credit accounts may freely interchange reference,
b) Bank reference each to the other, and without divulging their
c) Finance company references information under their own name. Credit
d) Supplier credit references bureaus provide an impartial information on
e) Credit information bureaus medium debtors and creditors among
f) Securities and exchange commission creditors themselves. In Metro Manila, we
have Eastern Inspection Bureau, Credit the financial trends or direction. Moreover,
Management Association of the Philippines, the financial statements should be ideally
founded in 1931 with present membership audited by a reputable external and
of some 360 firms, the Credit Information independent auditor/certified public
Bureau, Inc. has been supported by the accountant; the audit certification should
Central Bank of the Philippines. Currently, also declare whether it is qualified or
all bank checking is conducted only through not-noting what exceptions are found in the
CIBI where all banks are subscribers. reports as to affect materially the firm's
The Securities and Exchange Commission financial condition as of a specified
is the chief source of information about the accounting date or period; lastly, the
legal business registration of corporations financial reports should be identified
and partnerships. Information regarding whether it represent the statement of
business name, ownership, capitalization, financial condition of a single entity
board membership, business addresses, (unconsolidated) or that of several entities
and primary and secondary business as a group (consolidated).
operations are available at the SEC. Sole In brief, the financial analysis involves:
proprietorship is registered, on the other 1)​ Balance Sheet Review examines the
hand, with the Bureau of Domestic Trade. quality of account of items under
Known business associates of a credit each category of current assets as
applicant are considered to be significant against those under current
information source because personal liabilities, to determine how
contacts for both business and social financially liquid is the entity.
interaction puts them in a good position to Likewise, test for quality the fixed
appraise the personal integrity and general assets against non-current liabilities.
personality of the borrower. To ascertain how leveraged the
E. Analyzing the Financial Condition of a company is, compare the ratios
Borrower between total liabilities versus the
The financial statement, made-up of the owners' net worth, after
balance sheet, also called the statement of necessaryadjustments, if needed,
financial position, the income statement shall have been done. Bear in mind
otherwise called the profit and loss that the balance sheet depicts the
statement or statement of operating results, general financial condition of a firm
including the summary of sources and only as of a specific date.
application of funds or statement of funds, Concentrate on proportions and
serve as the basic source of financial trends for major account items.
information to ascertain aa borrower's 2)​ Profit & Loss Statement reports
liquidity, leverage, net worth, and profitability what and how well the business
as a going-concern enterprise. entity has performed in its
For purpose of conducting an in-depth operations over a given period of
financial analysis, which unfortunately very time its ending date must coincide
few lenders do seriously, except the with that f the balance sheet, ex. 12
commercial banks, the financial statements months or one semester.Normally,
to be south from borrowers should be on a the P&L is composed of sections
historical 3-year basis to be able to draw out such as:
 Income statement analysis is generally
directed towards answering questions about
the business:
(1) Profitability, and
(2) Operating efficiency.
Both factors point to a firm's ability to
generate and maintain a satisfactory level of
earnings and ability to meet market
competition by ably controlling its production
and selling costs that result to a reasonable
margin of profit for products produced and
sold. The illustration 7 represents an
example of a condenses and comparative
analysis of income statements.
A device in analyzing statements may be
used by expressing all items on the balance
sheet as percentages of total assets and
also all items on the income statement as
percentages of the net sales. This is called
common-size analysis. This means that
total assets in the balance sheet will be
assigned 100% and each individual item
therein as a percentage of the total 100.
The same concept will be applied in the
case of the income statement, using net
sales as the base item at 100% and the
individual items therein as percentage
components.
Common-size statements are very useful
and convenient when comparison is being
A meaningful analysis of the income made of two or more companies, or of one
statement involves close scrutiny of the company with the financial statements for
different account sections, testing its quality the entire industry. It should be emphasized
and accuracy, drawing out proportions and that a study of common-size statements
percentages of the different items using the serves as a starting point in analysis.
net sales as the index number at 100 Variations should be traced and it would be
percentage points, and making comparisons necessary to discover the reasons therefore
and measurements based upon the by further detailed analysis.
financial data for two or more like periods.
Footnotes and auditor's qualifications for the
current and preceding periods which are of
continuing significance should be noted.
 will be helpful to draw conclusions about a
firm's performance in the light of market
competition.

3. The Spread Sheet the preparation of

The condensed comparative income
which serves as the first step in financial
statement of New Manila Enterprises, Inc. is
analysis. Several advantages can be gained
also illustrated in the next example (Figure
through its use. E.g.:
F-3) of common-size profit and loan
(a) The trend of the company's operations
statement. The percentages were drawn
becomes much more apparent when data
from the
from successive statements are recorded in
The common-size statement examples cited
comparative form.
in this section shows its use for a company's
(b) Data can be condensed and simplified
internal review of major changes in some
from voluminous statements, making
individual items in the financial statements.
analysis easier.
If industry averages are available, such data
(c) It provides an opportunity to reclassify
can be included to develop comparison, and
statement items where necessary for a
any substantial deviations will have to be
more meaningful analysis.
further studies as to causes or reasons
(d) It provides a place for recording
therefor.
significant ratios and reconciling changes in
Analysis of common-size financial
working capital and net worth.
statements for credit purposes helps to
(e) The analyst and the credit decision
crystalize in the mind of the analyst. The
maker can be quickly refreshing their
major components of the balance sheet and
memory as to the general financial structure
profit and loss statement of companies
and condition of the company without
which are involved in different industries.
necessarily having to leaf through the
Subsequently, through a number of years'
individual statements.
experience analyzing financial statements,
Although the spreadsheet in itself will
the analyst can be relied upon to spot any
develop much pertinent information, its use
improper financial proportions between
is not necessarily the final step in analysis,
company assets, liabilities and equity.
after which the statements can be
Operating data can be also matched against
disregarded. Many of the factors pointed up
industry averages and should induce the
by the spread sheet will turn the analyst
analyst to make in-depth investigation which
back to the financial statements or to the
borrower himself for further information. The
spread sheet, therefore, is considered as a
useful tool in making analysis of financial
statements in a convenient form that is
standardized and concise.
In the following pages are illustrated
(illustration 8) the original FS of our example
company, Nicefoods, Inc., which after
verification, reclassification and notation of
some accounts involving significant
amounts which could materially affect the
financial position of the company have been
translated into the spread sheets. Notice the
impact of changes upon the company's
current assets and current liabilities.
Similarly, note the changes in working
capital and net worth. The illustration further
shown at a glance the summary of the
company's operating performance and the
relevant ratios and percentages. It should
be borne in mind that a more meaningful
financial analysis should involve at least two
ILLUSTRATION 8 - The Financial
years' operating performance to see trends
Spreadsheet of Nicefoods, Inc.
of performance results. Refer back to
To prepare the spread sheet of Nicefoods,
illustration 7 regarding New Manila
Inc. the balance sheet and the income
Enterprises, Inc. If financial data were
statement must be tested for quality and
complete for Nicefoods, Inc. over a period of
veracity of the account items categorized.
three years, the same could be spread to
The auditor's footnotes and even some
show the performance trends.
explanations from the financial officer of the
firms should be sought so that the data
appearing in the spreadsheet would be
realistic for proper evaluation. The pages
immediately following complete the
illustration.
 and the contribution of funds derived from
operations to the growth of the company.
They may also provide clues as to the future
financial requirements. Characteristics:
It is a condensed report of how the activities
of the business have been financed, and
how the financial resources have been used
during the period covered by the financial
statement.
The principal raw materials used in the
preparation of the "funds" statement
consists of comparative balance sheets,
beginning and end of the period. The net
changes which have taken place in the non-
current accounts are calculated and the
statement organizes this material into two
groups, (1) sources and (2) applications or
some similar titles (disposition, use of funds,
received and disbursed, generated and
F. Source and Application of Funds
expanded, etc.). Sources of funds are
Purpose:
indicated by decreases in non-current
A complementary statement presenting
assets and increases in non-current
information which cannot easily be obtained
liabilities and net worth. Applications are
from the other financial exhibits. It
associated with increases in non-current
contributes materially to the answers to
assets and decreases in non-current
such questions as:
liabilities and net worth. We do not consider
1. Where did the profits go?
changes in current assets or current
2. Why is working capital down although
liabilities because the word "Funds" in the
operations were profitable?
statement refers to "working capital funds",
3. Why is working capital up even though
and since working capital is the net
operations were not profitable?
difference of current assets over current
4. What happened to the proceeds derived
liabilities, changes in the current accounts
from the reduction of non-current assets?
would already have been taken into
5. How was the retirement of debt
consideration. Also needed to prepare a
accomplished?
statement that will tell the most complete
6. Why were dividends not larger?
story, is the income statement for the period
7. How was it possible to distribute
covered and a reconciliation of retained
dividends in excess of current earnings, or
earnings statement.
in the presence of a net loss for the period?
SOURCE & APPLICATION OF FUNDS
And many other questions.
STATEMENT
Several years of Comparative "funds"
The Source and Application of Funds
statement, covering operations, enable the
Statement is designed to show the
reader to obtain useful information such as
movement of current funds through the firm.
the financing methods used in the past,
Although other concepts may be
dividend policies which have been followed,
encountered in practice, funds in the Rules for funds flow analysis
following discussion will be defined as Sources of Funds
working capital (current assets minus -​ Increase in Liability
current liabilities). Thus, the statement -​ Decrease in Asset
shows as sources of funds the reasons -​ Increase in Equity
which cause working capital to increase and Uses of Funds
shows as applications those things which -​ Increase in asset
cause working capital to decrease. Net -​ Decrease in Liability
incomes and the sale of bonds are example -​ Decrease in Equity
of sources of funds whereas dividends and -​ Loss from Operations
purchases of plant and equipment are *Before accounting write-offs
examples of applications of funds. G. Financial Statement Ratios
The sources and Application of Funds The lender's purpose in analyzing financial
statement is important because of the statements is to appraise the extent and
importance of funds to various nature of the risk involved and to help
decision-making groups. Management, determine the ability of the prospective
investors, and credit grantors are all debtor to repay a proposed loan in
interested in the ability of a firm to pay accordance with its terms. The lending
debts, to pay dividends and to generate officer must not become involved in the
funds for plant expansion. The Source and figures of a business to the extent that he or
Application of Funds statement is useful in she neglects the primary considerations of
determining the following: character, managerial ability of the
(a) What has happened to funds generated applicant, and the purpose of the loan.
by operations? Ratio analysis of financial statements must
(b) How were purchases of plant and be preceded by careful thought as to the
equipment financed? kinds of insights the lending officer or the
(c) Were sufficient funds generated from analyst wishes to obtain. Ratios are not
operations to adequately cover dividends? ending in themselves, rather, on a selective
An example of a Source and Application of basis they may help to answer significant
Funds Statement follows: questions. Keep in mind the following useful
hints:
1) Select only date which are relevant to the
analysis. The purpose of the investigation
itself yields clues to the nature of the ratios
which will be helpful.
2) Extend your analysis over several past
periods as well as for the current period, to
be able to observe any noticeable trends.
3) Concentrate on all major variations from
any applicable standards, such as industry
data, especially if there is a consistent trend
over a period of time, and attempt to
analyze their causes by cross-checking with
other ratios and raw data.
The computation of ratios assists the
analyst in considering significant financial
statement relationships. Refer to illustration
in this section. The selection of the best
ratios for a particular business firm is
determined by the purpose of the analysis.
For example, a short-term creditor is most
interested in liquidity ratios; a long-term
creditor or investor is more concerned with
profitability ratios.
A word of caution: ratios are only as good
and as meaningful as the financial data and
exhibits are accurate. Keep in mind that
seldom are figures on financial statements
truly "accurate". They are generally
reasonably good approximations.