Study: What are creditors and what information do creditors use to make credit decisions?
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Slide 1: (:14s)
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Welcome to Introduction to Accounting Preparing for a User’s Perspective.
What are creditors and what information do creditors use to make credit decisions?
Slide 2: (:14s)
Links to an external site.This video will discuss different types of creditors such as banks, manufacturers, wholesalers, retailers, service providers, and employees.
Slide 3: (:25s)
Links to an external site.What are creditors?
In general, creditors can be classified into two groups 1) lenders
Links to an external site., which are those that loan resources to borrowers and charge interest
Links to an external site., and 2) suppliers and service providers that sell goods and services on account and don't charge interest.
Slide 4: (:30s)
Links to an external site.How is a lender a creditor?
Jill will represent lenders. Jill lends a certain amount of resources, called principal
Links to an external site., to borrowers, then charges a fee, called interest, for using the principal. Over the life of the loan, if all goes well, Jill will receive interest payments, classified as a return ON principal, as well as a return OF the original principal she lent out.
Slide 5: (:39s)
Links to an external site.In a later module we will dig deeper into the computation of interest but here is the basic formula for computing simple interest on a loan. You take the principal amount outstanding, multiply by the interest rate charged, which is usually quoted as an annual rate, multiply that by the time period since the last interest computation, and you will arrive at the interest charged for the time period involved.
The simple interest formula is one of the most basic formulas of finance and is foundational to the idea that money has a time value Links to an external site..
Slide 6: (:13s)
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For example, $10,000 in hand today has a greater value over time than receiving $10,000 a year from now. Why is that true?
Slide 7: (:39s)
Links to an external site.Because if you have $10,000 in your hand today, you could actually do something with it to earn more money such as lend it to someone for a year at 7%. If you were to do this AND the person were to pay you back as promised, you would have $10,700 a year later ($10,000 return OF principal + $700 return ON principal represented by interest (which would be computed as $10,000 principal * 7% annual interest rate * 1 year of interest).
Slide 8: (:25s)
Links to an external site.So, if you learn nothing else from this course, all else being equal, if someone were to give you the choice to receive $10,000 today or $10,000 a year from now, I hope you will choose to receive $10,000 today. But, if your choice is either to receive $10,000 a year from now or receive nothing at all, go ahead and choose $10,000 a year from now.
Slide 9: (1m:51s)
Links to an external site.How are suppliers and service providers creditors?
Gill will represent suppliers and service providers. Gill provides goods and services to customers "on account". By selling to customers "on account" he first provides his customers goods or services and then waits to be paid later. As long as Gill's customers pay him for the goods and services within a reasonably short period of time, usually within 30-60 days, Gill will not charge them any interest. Creditors like Gill often choose to sell to customers "on account" because so many of them are unable to pay cash upfront but can pay cash later if they are given sufficient time to pay.
Gill could also represent employees as service providers because employees often provide services to their employers "on account". They work first and then get paid later. In addition, Gill could represent electric or utility companies (such as water, gas, phone, cable, sewage, etc.) that provide utility services to customers, then bill them asking them to pay later. When customers owe money to suppliers and service providers the amounts owed are referred to as payables. For example, the customers who purchase goods on account owe an account payable Links to an external site. to the supplier. Company's who owe their employees for work performed on account owe wages or salaries payable. Company's who owe utility providers for utilities received on account owe utilities payable. Gill could also represent a manufacturer, who produces the goods and then sells them to customers. Company's who owe manufacturers for products they purchased on account owe accounts payable.
Slide 10: (1m:8s)
Links to an external site.For this course, we will call both groups of credit providers, the lenders (Jill) and the suppliers and service providers (Gill), creditors. When owners, such as Bill, provide resources to a business, such financing is called equity financing and is considered permanent financing. On the other hand, when creditors provide financing to businesses, such financing is called debt financing and is considered temporary financing. Debt financing causes two things to happen in a borrowers' accounts. First, the borrowers' resources, known as assets, will increase. Some common assets are cash, inventory, accounts receivable and equipment. Second the creditors' claims against the borrower, known as liabilities, will increase. Some common liabilities are accounts payable, salaries & wages payable, utilities payable and notes payable. The owners' equity account will not be immediately affected.
Slide 11: (1m:22s)
Links to an external site.For example, let's take a look at how a company might finance $100 in assets. It could either borrow the money, represented by liabilities, or the owners could provide it, represented by equity. For this example, let's assume that the amount of assets financed by the owners via equity financing is only $30. We could then deduct this $30 from both sides of the equation to solve for the amount of liabilities caused by debt financing. Using this math we can conclude that $70 of the company's assets were funded through debt financing and will be called liabilities.
What the solution to this equation indicates is that any assets that were not funded by its owners (i.e.equity, equity financing), must have been funded by creditors (i.e. liabilities, debt financing), and vice versa. When this mathematical equation is written as Assets = Liabilities + Equity, it is called the balance sheet equation. Based on the balance sheet equation, it should be clear that any assets not funded/claimed by creditors, must have been funded and can be claimed by its owners, and vice versa.
Slide 12: (2m:20s)
Links to an external site.What type of borrowers do creditors normally want to grant credit to?
From a creditor's perspective, creditors want to lend to entities that will pay them back with interest. With that in mind, let's look at an example. Let's assume that you are Jill and you are ready to lend $10,000 to someone at an 8% interest rate. Your options in this example are to lend to:
a) an A+ quality borrower who will very likely repay the loan in full plus interest as promised
OR
b) a D- borrower who very likely may not repay the loan in full plus interest, contrary to what was promised.
I assume that given the two choices above, you, as well as everyone else in the world, would choose to lend to the A+ quality borrower. Given the current facts, that is a good choice. However, does it really make sense that an A+ borrower who has very little risk of defaulting on the loan would have to pay the same interest rate as a D- borrower who has a very high risk of defaulting? Absolutely not! The basic economics of supply and demand Links to an external site., would result in a huge demand to lend to A+ borrowers, thus driving down the interest rates for A+ borrowers, and very little demand to lend to D- borrowers, thus driving the interest rate for D- borrowers up. In addition to charging A+ borrowers lower rates, lenders compete for A+ borrowers in other ways such as lending them larger amounts, requiring less or no collateral and not requiring any co-signors. At a minimum, it is likely that lending competition would result in A+ borrowers paying lower interest rates and D- borrowers paying higher interest rates. That is why companies with good credit ratings Links to an external site. and individuals with good credit scores have lower debt financing costs than those with poor credit ratings and poor credit scores.
Slide 13: (32s)
Links to an external site.From a borrower's perspective, debt financing tends to be riskier to a company's cash flows than equity financing because debt financing is only temporary financing and must be repaid within a specific period of time. On the other hand, equity financing does not normally have a legally enforceable repayment horizon, and therefore is less risky to a company's cash flows, that is why it is often referred to as permanent financing.
Slides 14-20: (2m:20s)
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What information do creditors use to make credit decisions?
One of the challenges creditors have when trying to make credit decisions is obtaining sufficient information and properly analyzing it to distinguish between the A+ and the D- borrowers. The result of their analysis should help answer the following five key questions:
1) Do I believe this borrower or customer will have the ability to pay the money back as promised?
2) Do I believe this borrower or customer will have the integrity to pay the money back as promised?
3) When will the borrower or customer pay the money back?
4) How much should this borrower or customer be allowed to borrow or purchase on account ($1,000, $10,000, $500,000, etc.)?
5) What rate
Links to an external site., if any, should be charged?
An analysis of a potential borrowers' "credit-worthiness" is like a complicated puzzle. Some of the puzzle pieces are a company's credit rating (e.g. Dunn & Bradstreet, Standard & Poors, Moody's Investors Services, and Fitch group), an individual's credit report from a well-known consumer credit rating agency (e.g. Equifax, Experian, or Transunion), an individual's credit references from others who have done business with the potential borrower, information from the Better Business Bureau, information available online using a search engine (i.e. Google, Bing, Yahoo), as well as the company's general purpose financial statements which include the company's income statement, statement of equity, balance sheet, statement of cash flows and the related footnote disclosures. Aside from the specific information about the potential borrower, other information such as macroeconomic trends Links to an external site. can also influence a creditor's credit-granting decision.
This course will focus on understanding how to prepare, and use one of the key pieces of the credit analysis puzzle particularly the general purpose financial statements.