Is accounting helpful in raising loans
Answers
Companies finance their operations with a combination of debt and equity. The terms and amounts of these loans and capital contributions affect the health and financial condition of the business.
From the principles of accounting, the accounting equation states that the total assets of a company equals the sum of its liabilities and equity contributions on the balance sheet.
What Is a Balance Sheet?
A balance sheet lists the total assets and liabilities of a company. Assets include cash in banks, accounts receivable, inventory and fixed assets. Liabilities are amounts owed to suppliers, short-term debt, long-term debt, and total equity contributions and retained earnings.
How Is a Loan Recorded on a Balance Sheet?
As an example to illustrate the loan accounting procedure for a new loan in the records of a business, suppose a company, the Hasty Rabbit Corporation, obtains a loan for $125,000 to purchase equipment for its production line. The loan has a fixed interest rate of 7 percent and will be repaid over 10 years.
The bookkeeper enters this loan into the accounting ledgers of the business by recording a credit in the amount of $125,000 into the long-term debt account and a debit to the company's cash bank account. When the company purchases the equipment, the bookkeeper records a credit for $125,000 to the cash bank account and a debit to the fixed asset account for equipment.
The accounting equation is satisfied because both assets and liabilities have increased by the same amount, $125,000, and assets still equal liabilities plus equity.
How Does a Loan Affect the Balance Sheet?
One measure of the financial health of a company is the proportion of its debt to equity. Generally, a comfortable ratio of debt to equity for most industries is a 1:1 ratio. In other words, the company would have $1 in debt for each $1 in equity.
Still using this example, let's assume that before the $125,000 loan, Hasty Rabbit had $175,000 in total debt and $225,000 in equity. This is a debt/equity ratio of 0.78 ($175,000/$225,000).
After the new loan, the debt/equity ratio goes up to 1.33 ($300,000/$225,000). This ratio is still not too high, but it does place some constraints on the future borrowing capacity of Hasty Rabbit. Creditors do not like to lend to companies with high debt/equity ratios; they are more concerned about the company's obligation to meet its annual debt service commitments out of cash flow.
What Is the Effect of a Loan on Cash Flow?
Another metric used to gauge the financial health of a company is the ability to pay its interest and loan amortization obligations out of its cash flow.
Before the new loan, Hasty Rabbit had free cash flow from operations of $105,500/year and annual interest and loan payments on the $175,000 debt of $31,500. This calculates to a debt service coverage ratio of 3.4:1 ($105,500/$31,500). In other words, the company is generating $3.40 in cash flow for each $1 in loan and interest payments.
The interest and loan payments from the new loan of $125,000 will increase the company's annual debt payments to $52,750 ($31,500 + $21,250). The debt service ratio is now 2:1 ($105,500/$52,750). This is not a comfortable margin of safety in the event of a decline in revenues and cash flow.
Business managers try to finance their operations with a prudent balance of debt and equity. Generally, the cost of debt is cheaper than the return investors require on equity contributions, so it would make sense to borrow as much money as they can. However, lenders follow practical considerations of debt/equity ratios, and debt service coverage ratios place limits on the amount of debt that a company can incur.
mark as branlist answer