A balance sheet presents the company’s financial position at a given moment in time. Even if your borrower’s statements are prepared in accordance with Generally Accepted Accounting Principles (GAAP), the amounts shown on the balance sheet often don’t reflect current market values — and many valuable items are even omitted.
Here’s what your borrower’s balance sheet isn’t telling you, as well as some diligence procedures that can help you evaluate your potential risks and return.
Differentiating historic cost from market value
Under GAAP, assets are, for the most part, recorded at their historic acquisition cost. Some permanently impaired long-term assets may be written down to market value. But assets aren’t increased to their market values.
Over time, an asset’s historic cost (also known as book value) may grossly understate its current market value, especially if the asset continues to provide economic value but has been fully depreciated. This situation commonly occurs with long-term assets, such as buildings and machinery.
Personal property and real estate appraisals give business owners (and lenders) an indication of how much an asset is currently worth in the marketplace. Sometimes appraisals are obtained when the owner works on his or her estate plan or files for divorce. Any time a borrower obtains an asset or a business appraisal, request a copy; it provides valuable insight that financial statements cannot.
Eliminating artificial accounting metrics
Accounting rules have overriding priorities — such as conservatism and consistency — that compromise the real-world relevance of financial statements. So, some accounting methods don’t accurately reflect operating cash flows.
For example, the last-in, first-out (LIFO) inventory method is commonly used by small businesses to defer taxes. LIFO tends to understate profits and inventory — and exaggerate inventory turnover — in an inflationary market. A LIFO adjustment can provide additional insight into inventory values. The footnotes that accompany audited financial statements typically provide the needed information to make a LIFO adjustment.
The use of estimates also makes account balances speculative, especially if management is inexperienced or its estimates are otherwise inaccurate. For instance, unsophisticated borrowers may understate (or forget to subtract) uncollectible receivables, damaged or pilfered inventory, and obsolete assets.
Evaluate your borrower’s financial reporting conventions, as well as how it uses estimates, to determine what items might require adjustments to more accurately reflect economic reality. Some items may be worth more (or less) than what’s reflected on the balance sheet.
Searching for hidden accounts
Balance sheets may also omit some of the most valuable assets and significant liabilities. Intangible assets aren’t recorded on the balance sheet unless they were purchased from a third party. But they may make up a significant portion of an entity’s fair market value, especially for service or high technology firms. Examples include customer lists, proprietary software, patents, trademarks and goodwill.
These assets can be difficult to appraise. But their values are generally a function of projected future cash flows, the asset’s remaining useful life and the expected rate of return for similar intangible assets.
Contingent assets and liabilities are also important to consider. These include warranties, unfunded pensions, pending litigation or insurance claims, environmental contamination, and earnouts on past business combinations. Your underwriters may decide to adjust a borrower’s loan covenants — such as the loan-to-value or debt-to-equity ceilings — to account for these incremental assets and liabilities.
Requesting outside assistance
Lenders often evaluate borrowers based on financial statement benchmarks, which may be skewed by historic costing conventions. The current market value of assets and liabilities also may be relevant if you’re financing a merger or an acquisition.
An entity’s financial statements tell only part of the story. Financial advisors can identify value discrepancies, artificial accounting practices and hidden accounts that require adjustments to better align the numbers with economic reality.