Before you give the green light for a business loan, you conduct due diligence. But if you only review past financial statements, you’re not seeing the full road ahead — and that road might be littered with hazards. Instead, consider tweaking your examination.
Assessing the risks
Start the process as an auditor would. That is, before you open a borrower’s financial statements, take a minute to think about the industry, economic conditions, sources of collateral and business operations.
This assessment identifies what’s most relevant and at risk, what trends you expect in this year’s financials, and which bank products the customer might need. Risk assessments save time because you’re targeting due diligence on what matters most.
Being “in the know”
Now tackle the financial statements, keeping in mind your risk assessment. First evaluate the reliability of the financial information. If it’s prepared by an in-house bookkeeper or accountant, consider his or her skill level and whether the statements conform to Generally Accepted Accounting Principles (GAAP). If statements are CPA-prepared, consider the level of assurance.
Comprehensive statements include a balance sheet, income statement, statement of cash flows and footnote disclosures. Make sure the balance sheet “balances”; that is, assets equal liabilities plus equity. You’d be surprised how often internally prepared financial statements are out of balance.
Statements that compare two (or more) years of financial performance are ideal. If they’re not comparative, pull out last year’s statements. Then, note any major swings in assets, liability or capital. Better yet, enter the data into a spreadsheet and highlight any change greater than 10% and $10,000 (a common materiality rule of thumb accountants use for private firms).
Now ask yourself whether these changes make sense based on your preliminary risk assessment. Brainstorm possible explanations before asking the borrower. This allows you to apply professional skepticism when you hear borrowers’ explanations.
Using key metrics
Use your risk assessment to create a scorecard for each borrower and refer back to it from year to year. It often helps to discuss your risk assessment with co-workers and to specialize in an industry niche.
One ratio that belongs on every scorecard is profit margin (net income / sales). See the sidebar “The importance of the profit margin.”
The current ratio (current assets / current liabilities) measures short-term liquidity or whether a company’s current assets (cash, receivables, inventory and so forth) are sufficient to cover its current obligations (accrued expenses, payables, current debt maturities). High liquidity provides breathing room in volatile markets.
Another useful ratio is total asset turnover (sales / total assets). This efficiency metric tells how many dollars in sales a borrower generates from each dollar invested in assets. Again, more in-depth analysis — for example, receivables aging or inventory turnover — is necessary to better understand potential weaknesses and risks.
And if you want a snapshot of a company’s ability to pay interest charges, calculate its interest coverage ratio(earnings before interest and taxes / interest expense). The higher a borrower’s interest coverage ratio is, the better positioned it is to weather financial storms. Interest coverage ratios may be more meaningful than debt-to-equity ratios to the extent that the book value of equity differs from fair market value.
When evaluating these metrics, compare a company to itself over time and benchmark it against competitors, if possible. These scorecards provide a launching pad for borrower meetings. If customers’ explanations don’t make sense, consider requiring them to hire a CPA to perform an agreed-upon-procedures engagement, targeting specific high-risk areas.
Customizing your approach
No two borrowers are exactly the same. Customize your approach for different lines of business and niches that come with their own sets of risk, opportunities and likely sources of collateral.