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THE MOST OVERLOOKED WAY TO LEGALLY DECREASE TAXES IN 2005
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Understanding Financial Statements When Approaching Lenders
“The bank is asking for our financial statements”, these are 8 words that often bring apprehension to many business owners. They are a young and maybe struggling company, they need bank financing to survive, and they haven’t got a clue what the financial statements are telling them, what they should be looking at, or what the bank wants to see. Many will delay providing the required financial information to the bank, but this is the worst thing you can do. Going to the bank shouldn’t bring on apprehension. Having a basic understanding of financial statements and being prepared when you approach a bank, or any investor, will go a long way in reducing your apprehension.
The Basics
The bank, or any investor for that matter, uses financial statements to tell them what happened in the past. Statements are also used as a means to predict what will happen in the future. Creditors are concerned about whether income (cash flow) will be sufficient to cover interest and principal payments on their debt. Of course, predicting profits into the future is an uncertain science. For this reason, creditors use various analytical tools to help them assess and interpret key relationships and trends that will help them judge the potential of success in the future. It also helps them predict whether a firm has sufficient resources to handle a temporary financial crisis.
Financial statements are historical documents covering single time periods. Users of financial statements, however, are not so much concerned about the single time period as they are about the trends over time. Trend analysis is usually completed on key indicators, such as revenues, gross profit margin, operating expenses, and working capital components such as accounts receivable, accounts payable and inventory. Through comparison of ratios and trends you can make informed judgments as to the significance of results. That is why banks or other investors often want 2 or more years of business results before they will lend.
Although trends and ratios are a starting point, they can often raise questions, the answers to which you can only get through analyzing industry trends, economic factors and the company itself. Typically, unless you are a master of presenting information, bank lenders will ask questions of you and your business. This is normal as they are trying to learn as much as possible about you and your business. Once again, be prepared, this will show you understand your business and its finances and that will make the bank more comfortable in lending to you.
The Balance Sheet
Banks primarily lend off the balance sheet and the cash flow statement (primarily operational cash flow). That does no mean that the income statement is not important, it is, but the balance sheet essentially encompasses what happens on the income statement and the cash flow statement tells a lender whether you are actually generating enough free cash flow from which you can make debt payments.
So what is important on the balance sheet?
Working capital
Current assets minus current liabilities, working capital tell us how much short-term assets we have to pay off short-term liabilities. The greater the amount of working capital the more funds a company has to finance its growth. A negative number is not good and can signify pending trouble. A typical rule of thumb is a ratio of assets over liabilities of 1.5:1. Questions you need to be able to answer are: trends in the ratio, what are the components of the assets and liabilities and how liquid are the current assets (for example, not all inventory can be liquidated quickly).
Accounts Receivable
You want to maintain your receivables in line with industry standard, or better. High growth companies can often have a high growth rate in receivables that they need to finance, but the average number of days outstanding should not get out of hand. If they do, for example climbing from 60 to 90 days or more, this often indicates a weakness in management. If this happens be prepared to have a plan in place to reduce the outstanding receivables. A lender will typically look to answer the following: is there a concentration to a few buyers, what are the age and terms of the receivables, what is the quality of the receivables and what is the value of the receivables in a liquidation scenario?
Accounts Payable
As with receivables, you need to maintain payables in line with industry standards. Often, growing companies will let payables stretch to finance growth, this is ok in the short-term as long as the payables don’t go overdue and you maintain good relations with your creditors. Once again, the age of the payables will be looked at as well as any concentrations to a few creditors. Make sure all payables are up-to-date and any security priorities should be noted.
Inventory
The composition of inventory needs to be evaluated. What amount is work-in-progress and what amount is finished goods? Obsolete inventory needs to be closely monitored. Banks will look at the potential obsolescence of inventory before they lend on the value. Often they are not interested on lending on goods that have no or little value if the business ceases operations. This often frustrates business owners, but it is a reality they need to deal with. Showing that there are strong controls around inventory can often help a business owner's case with the bank. If you are
exporting large ticket items internationally, look to having your receivables insured.
Equity (Tangible Net Worth)
When I refer to equity, I really mean tangible net worth or the equity in a business less any intangible assets. Intangible assets can include (but are not limited to) goodwill, patents and sometimes prepaid expenses. Depending on the arrangement with the bank, shareholder loans may or may not be considered as part of the equity base. A ratio of tangible net worth to total debt of 1:1 or better is a good goal to shoot for. Basically, the bank wants to make sure that the owner has also invested in the company, that the company can support its present and future endeavors and that it has the ability to withstand any unplanned declines in business.
Debt
Having debt is not bad, but having too much debt is. Look at what the make-up of your debt levels are and what the debt has financed. Does the maturity of the debt properly reflect the related assets? Is there any term debt supporting working capital, or revolving debt supporting long-term assets? If the answer is yes then you should look at restructuring the debt to properly reflect the assets. Review the company’s debt in relation to the company’s cash flow and assess its ability to meet debt obligations. Do you have the required credit available to meet seasonal borrowing requirements?
Inter-company assets/liabilities
Keep in mind that the bank will not lend off of inter-company receivables. Next, you should be able to answer the following questions: are the assets liquid and do they have value, can the related company meet its obligations, what are the terms of outstanding debt, is there any off-balance sheet debt or assets, can funds flow freely between the companies?
The Income Statement
The income statement provides information on a firm's operating activities over a specific period of time. In simple terms it is revenues less expenses. However, as is seen by all the accounting scandals recently, how those revenues and expenses are recorded can often be left open to interpretation and manipulation. A lender is well aware of the manipulation that can occur and so will look at the income statement carefully. If there are any “gray” areas the lender will want clarification, so be prepared to be able to answer any questions asked of you. Or, have your accountant prepared to answer any questions.
As with the balance sheet, a lender will rely heavily on trends and key ratios and will want to know the why of any significant movements in these ratios. Key areas they will focus on are the growth or decline in sales, net profit, gross margin and administrative expenses.
Important areas you should be aware of are:
• Are you expensing or capitalizing expenditures?
• Are operating profits stable?
• Are there areas of weakness? If yes, what action is management taking to work on these weak areas?
• Are there any extraordinary losses of gains?
• Are inter-company transactions having an impact on profits?
• What transactions are being completed to minimize profit and tax?
The Cash Flow Statement
The cash flow statement is a summary of a company’s cash flow over a period of time. It is basically actual (i.e. not accrual) cash receipts less actual cash payments. A cash flow statement will have 3 parts to it: 1) cash from operations, 2) cash from investing activities and 3) cash from financing activities. The bank will be most concerned about cash from operations as this tells it whether the company can generate sufficient cash from day to day business activities to repay loans. However, it is still important to be able to generate a cash surplus after all activities – i.e. operations, investing and financing. The quality, consistency and sustainability of cash flow is key.
Important areas you should be aware of are:
• Changes in working capital – movements in accounts receivable and payable and inventory, especially for a growing company, can mean a company is a net user of cash. This may indicate liquidity problems.
• Look at ratios such as sales to cash from operations and interest and principal payments to cash from operations. Negative trends can indicate lack of controls, inefficiencies or bad investment decisions.
• Look at factors that may impact total cash flow (cash from all activities) such as dividend distributions and taxes.
• Are there any extraordinary items affecting cash flow?
• Are there any capital expenditures which may have a negative impact on total cash flow?
• Examine the relationship between the change in sales and the change in cash flow. Are there any weak spots such as a declining gross margin? What action is management taking?
As you can see that there is a lot of information that needs to be assessed. That is why it can take a few days to get back with lending decisions, particularly if the statements are complicated. The goal is to provide you with a basic understanding of what is being looked at so you can be prepared when approaching your lender. As always, the more prepared you are, the better chance of success you have.
About the Author
Jeff Schein is a CGA and offers consulting and advice in the areas of business planning, strategic planning, business analysis and financial management for new ventures and growing small businesses. Send mail to:jeff@companyworkshop.com
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