In this activity, we link personal and corporate finance to understand why people sometimes behave like corporations, and vice versa. We begin by asking why firms issue financial statemen
In this activity, we link personal and corporate finance to understand why people sometimes behave like corporations, and vice versa. We begin by asking why firms issue financial statements. Firms that sell ownership shares to the public are required by law to issue financial statements (see SEC, “The Laws That Govern the Securities Industry”), but many other firms also publish similar financial information describing income, assets, and liabilities. Individuals are asked to produce some of the same information as they apply for loans and credit. In this Discussion, we think about the mortgage loan application process to better illuminate information gleaned from a firm’s four key financial statements. Similarities exist between documentation requested of an individual applying for a loan and a firm accepting funds from investors. We explore why this may be true to understand the key financial statements.
Jucheng’s Loan Application
You are a loan offer at a community bank. You are working with a client Jucheng, who is referred by Dave. Dave is a friend of Jucheng, and Jucheng is now working with you to secure his first home loan. With acceptance of Jucheng’s offer on a home, he must secure financing.
Jucheng is currently applying for a home loan while Dave applied recently. Differences in Dave and Jucheng’s financial situations distinguish them as loan applicants. Both loan applicants are buying homes of similar value and their income is similar.
Jucheng only recently accepted employment offering stable income, something he has not had in the past. Jucheng finds it harder to show a record of stable income and employment to meet income documentation requirements. Jucheng’s income has historically been irregular. He supplemented his earnings with the sale of imported Asian Medicinal products but revenues from Jucheng’s supplemental income have also been historically irregular. Jucheng manages each of his business enterprises as Sole Proprietorships. Family contributed funding. He also has personal responsibility for business debts, including a business line of credit with balances and payments that are high in relation to his business income. Jucheng’s amount of savings is low.
Dave has had a stable source of income and has not moved between firms for many years. He has low debt in relation to his assets. Investments listed on Dave’s mortgage loan application counterbalanced the liability of the mortgage loan. The origin or his down payment is savings from past earnings, so his financial “claim” to these funds is clear. He had made no major purchases in recent years and had no major changes in his financial situation. Always having stable income, Dave pays his debts on time. His debt to income ratio is low.
From the perspective of the lender, Jucheng’s request for a loan is more problematic than Dave’s because Jucheng is less able to document his income, assets, and liabilities. The bank needs information to prove that a borrower is likely to repay a loan. Investors considering investing in a firm are interested in similar issues.
You are in a trusted position, aiding community members seeking mortgages, but also assuring that interests of savers of this small bank are safeguarded by your due diligence. You work closely with underwriters Links to an external site.to ensure documentation of consumer credit applications is in place at loan origination Links to an external site.. You notice Jucheng is new to the process guaranteeing a borrower’s ability for repayment and general financial stability. You are torn between empathy for Jucheng and an ethical regard for your fiduciary duty as an agent for this small bank. As a loan officer you recognize that Jucheng has difficulty documenting claims to his assets, including the origin of his down payment and his income. You wonder how you will explain the disappointing news that Jucheng may not qualify for a mortgage, even though he has enough income to cover payments currently.
Luckily, you are involved in a Financial Management course offering insight into the four key financial statements and measures derived from them used by firms to justify access to obtain capital markets. Using financial ratios derived from these statements as illustrations, you thus explain to Jucheng the reasoning behind documentation of income and earning ability, solvency, assets and debt, savings, and origins of assets that financial statements offer investors.
Speaking as a loan officer, you may use the case of these two borrowers to illustrate the points you make in this discussion.
- Briefly discuss why firms issue financial statements, considering any one category of user interested in these statements.
- Using any one type of financial ratio as an illustration, explain how financial statements offer a picture of a firm’s ability to serve as a good manager of invested funds.
- Discuss any one financial ratio that a financial institution might use to evaluate the the suitability of an applicant for a personal loan (as an example of one ratio, search for the term "debt-to-income ratio").
- Discuss the similarities between a corporate income statement and balance sheet and the documentation required of a mortgage loan applicant.
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