BUSINESS LENDING FINANCIAL SOLUTIONS Consulting Services 
Commercial Lending BasicsPart Two - Source of Loan Repayment and Analytical Process Just as there are only three primary reasons for business borrowings, there are only three basic means by which business firms can repay borrowings. 1. Reduce Assets
The purpose of the loan will inherently dictate which of the three repayment sources above is appropriate for any particular loan. If temporary assets are acquired, the subsequent reduction of assets to prior levels will produce funds for loan repayment. If permanent assets are acquired there is limited prospect of repayment from asset reduction. Repayment must come from cash flow produced by earned depreciation and profits being retained in the enterprise. If the purpose of the loan is not directly linked with a source of repayment, the lender must look to excess cash flow from existing operations and assets to repay the debt. Refinancing by another lender usually requires existence of a repayment source that will satisfy the replacement lender. In the long run, ability to generate positive cash flow is the ultimate source of repayment for a continuing concern. Assets can only be reduced to the minimum level necessary to sustain operations. Liabilities can only be increased to the extent that creditors can see a means of being repaid in the future. ANALYTICAL PROCESS In order to analyze or evaluate a specific loan request the lender must have sufficient information available to make as intelligent judgement about the probability of repayment. Knowledge of the purpose of the loan and understanding the nature of the business is a start. Three additional areas require investigation and analysis to determine that there are no weaknesses that would inhibit repayment. First and foremost is an evaluation of management. If management is not completely honest with an unblemished record of integrity there is no need to proceed any further. There is no way a lender can be protected against fraud and dishonest behavior. It is difficult to assess management character since it is best tested by adversity and many firms have not undergone serious adversity. However, there are signs that can indicate character weakness to which the lender must be alert. These include such things as behavioral patterns, associations, past credit history, and life style. The most important management factor after integrity is competency. Competency is the ability to manage the business and react to changing circumstances. Training and experience can improve competency, but neither is a guarantee of high competency. Management should have a plan for the business and be looking ahead rather than merely reacting to events as they develop. Appropriate controls should be in place in the firm to enable management to know what is going on and take action as needed. Depth of management and management succession are other important areas to evaluate, particularly if the loan under consideration will take several years to repay. The management system should be appropriate to the size, scope and stage of development of the business. Management can be at least partially evaluated by the record of past performance, frankness and timeliness of providing information, reputation in the general community, reputation with customers and suppliers, nature of employee relations and similar subjective observations. There are no reliable objective methods to rate management. It depends on the innate good judgement of the lender. The second general area for analysis is the position of the business in its market. Is the firm a leader or follower in its line of business? What is the strength of the market? What is the nature and strength of competition? What is unique about this firm? How does the firm differentiate itself from its competition? What is the state of technology in the firm and its industry? There are hundreds of questions that may need to be asked and answered in order to obtain a comprehensive understanding of the firm's present position and future prospects. The depth of required evaluation in this area will depend upon the complexity of the business and the length of time for which borrowings are being sought. Financial statements are the third important area for analysis. While management if fully responsible for the content and quality of the firm's financial statements, outside accountants or auditors are frequently employed to assist in statement preparations. If the statements are fully audited, the outside CPA's will be able to provide an unqualified opinion on them. Such an opinion indicates that the statements were prepared in accordance with generally accepted accounting principles applied on a consistent basis and the statements present fairly the financial condition of the firm. If the auditors have performed a full audit and are unable to give an unqualified opinion, they will either qualify the opinion indicating the reason for the qualification or disclaim giving any opinion. In some situations the outside accountants are not engaged to do a complete audit, in which case the accountant's covering letter will indicate that the statements have been reviewed and that without having performed a full audit, the accountants have no reason to believe that the statements are not reliable. In other situations, the accountants may merely compile the statements from the firm's books and records. Statements with no involvement by an outside accountant are known as "company prepared." Types of financial statements, as described above, in increasing order of quality for evaluation by a lender are: Company prepared - Prepared solely by the business enterprise. Compilation - Compiled by outside accountants from the company's books without audit. Review - Reviewed by outside accountants without audit, but with enough knowledge to indicate that generally accepted accounting principles have been employed to make the statements reasonable. Qualified Audit - A qualified opinion of the fairness of the financial statements based on standard auditing procedures with the qualification indicated. Unqualified Audit - A clean opinion of the fairness of the financial statements based on standard auditing procedures. The accuracy and reliability of the financial statements involved will influence the value of any analysis of them. The accounting principles used will also influence the analysis. For example, inventories presented on a LIFO (Last In First Out) basis will produce different statement relationships and ratios than the same inventories stated on a FIFO (First In First Out) basis. The method of depreciation used will have an impact on the level of fixed assets and earnings. It is critical to understand all the accounting conventions employed. Financial Statement Components Complete financial statements consist of six major components. Anything less is only a partial statement and does not permit full analysis. Accountant's Letter - Indicates the degree of outside review of the statements, Balance Sheet - Is a still picture of the uses (assets) and sources (equity and liabilities) of funding as of a specific date. Income Statement - Shows revenue earned over a specific period of time ending with the balance sheet date along with the costs and expenses incurred in producing the stated revenue. Remember, this is an accrual statement. Reconciliation of Equity - Accounts for the changes in the equity accounts between balance sheet dates. Sometimes this is incorporated at the bottom of the income statement. Statement of Cash Flows - Reflects changes in cash from operating, investment and financing sources and uses. Footnotes - Are additional data concerning accounting methods employed and details of major accounts and transactions. Each of these components plays a role in communicating to the reader what has taken place in the business enterprise. For purposes of evaluating cash flow the most useful and informative component is the Statement of Cash Flows. Financial Analysis Overview Analysis of financial statements requires a systematic approach to understanding what the statements say about the enterprise. Accounting is simply a language used to communicate the results of business activity in a stylized, numeric format. What the numbers represent is much more important than the numbers themselves. Since generally accepted accounting principles for business financial statements in the United States are generally based on historical cost, the numbers in the statements may not represent the current market for realizable values of the assets. The sequence in which financial analysis is conducted is not significant. It is important to cover all areas. Most lenders develop a pattern to their analysis to insure that everything is covered. It is important for each individual to establish their own routine pattern so that primary attention can be paid to the meaning of the analysis rather than the process. Before examining the numbers, it is important to understand the nature of the business being analyzed. The composition of and the relationships in the financial statements will be driven by the financial needs of the business based on its operating needs. Effectiveness of any analytical effort depends largely upon the reliability of the financial statements being analyzed. It is frequently helpful to start with a review of the manner in which the statements have been prepared the opinion of the accountant, and the footnotes prior to any in-depth look at the numbers themselves. Reading the footnotes first will frequently provide a better understanding of the individual numbers in the statement. The first footnote usually outlines the accounting principles used, including method of inventory valuation, depreciation methods, and the subsidiaries that may be consolidated or shown as investments. Other footnotes will usually deal with additional details on fixed assets, debt, leases, assets pledged, compliance with loan agreement covenants, deferred taxes, and other matters. More than one financial statement is necessary to do a valid analysis. Trends and direction of movement are more important then the position at any single moment in time. At least three, preferably five, fiscal statements are required to see trends clearly. For cyclical businesses, enough statements to reflect the prior business cycle will provide insight into the ability of management and the firm to weather and recover from downturns. If more than three months have elapsed since the last fiscal date, current interim statements are necessary to see how the current year is going. A comparable interim statement for the previous year enables comparison of the current position with the same time last year. For seasonal businesses a regular pattern of interim statements for several prior years will clearly demonstrate the seasonal pattern and any deviations. An early examination of the Income Statement will indicate whether the business is profitable or not. The existence of losses removes earnings as a potential source of repayment, unless there is clear evidence that profitability will be restored in the near future. Each individual account on the Balance Sheet and Income Statement should be examined to be sure that it's nature and relationship to operations is clear. Unusual items frequently require clarification from management or the accountant. Once the individual accounts are understood, the lender can move on to look at financial structure and relationships. Balance Sheet Assets are classified into three groups: Current, Fixed and other. Current Assets include all assets that are cash or its equivalent or will be converted into cash within one year from the date of the balance sheet through normal business operations. Prepaid Expenses are a Current Asset under generally accepted accounting principles, but are normally considered to be an Other Asset for credit analysis purposes. The same can be said for Supplies. From a credit perspective, current assets consist of trading assets (receivables from sales and inventory for sale) along with cash and cash equivalents. Fixed Assets consist of land, buildings, leasehold improvements, machinery, equipment, furniture, fixtures, vehicles and other tangible property that may be used in the operation of the business. Fixed assets, except land, are depreciable with the carrying value of the asset reduced over time by non-cash depreciation charged to the Income Statement. Depreciation results from the fact that factories, offices, machinery, computers, desks, chairs and so forth lose their value as they get older. The Internal Revenue Service recognizes this and allows businesses to deduct the lost value of equipment and buildings as they deteriorate or become outmoded. Both gross value (original cost) and net depreciated value should be shown for major categories of fixed assets. The relationship between original cost and accumulated depreciation provides and indication of the age of the assets involved. This may indicate a cash need in the near future for improvement or replacement or in the case of equipment with useful life far exceeding depreciation schedule, value in excess of book value. Some analyst consider leasehold improvements to be intangible assets, but in recent years they are usually routinely included in Fixed Assets since they are depreciable and their value can often be recovered through subleasing arrangements. Other Assets includes everything else. Such items as prepaid expense, deferred charges receivables due in more than one year, investment in affiliates, non-trade receivables, cash value life insurance and intangibles are commonly found in this category. Intangible Assets include goodwill, patents, franchises, licenses, unamortized organizational costs and similar items. Receivables from shareholders, principals or affiliates are often treated as intangible assets for credit analysis purposes. All intangible assets are deducted from equity to arrive at tangible equity for analysis purposes. Liabilities are classified as Current or Deferred. Current Liabilities are all items that are due and payable within one year from the balance sheet date, including payments due on term debt. Deferred Liabilities include the portion of term debt due after one year along with deferred taxes, unearned income and similar items. Any significant debt due shareholders, principals or affiliates is classified as current for credit analysis unless it is specifically subordinated to bank debt. Equity, or Net Worth, consists of the ownership investment in the enterprise in the form of proprietors' investment, partners' capital, stock, surplus, retained earnings, et cetera. These accounts represent the permanent capital committed to the business to which will accrue the profits or to which will be charged the losses. Specifically subordinated debt instruments can be added to the equity total to produce Adjusted Equity for analytical purposes. Working Capital is the difference between Current Assets and Current Liabilities. This is usually a positive amount representing the permanent funds available to support trading assets. Trade receivables and inventory tend to fluctuate with sales levels and are normally financed with trade payables, accruals, short-term borrowings and permanent working capital. The typical Trading Cycle consists of the acquisition of inventory, conversion to receivables through sale, collection of the receivables to produce cash for the payment of payables and accruals, and purchase of new inventory to start the cycle over again. To the extent profits are earned in the process, their retention in the business increases equity. If sales grow, this increased equity helps provide the additional working capital required to support increased sales levels. If the business is mature and sales levels remain relatively constant, the growing equity from profits can be used to finance additional business ventures or be paid out to the owners without harm to current operations. Ratio measurements of the current or trading asset position include: Current Ratio - Current Assets/Current Liabilities Quick Ratio - Cash + Receivables/Current Liabilities Trading Ratio - Receivables + Inventory/Payables + Short Term Borrowings The higher these ratios, the more trading assets are being supported by term debt or net worth. These ratios can be influenced by inventory accounting methods such as LIFO or FIFO. Comparison of these ratios with similar firms or industry averages will indicate the relative strength of a particular company. Trends in these ratios are more important than their magnitude at any single time. Increases indicate that additional working capital is being generated while decreases indicate diversion of working capital to other areas. Turnovers are another tool used to evaluate working capital and the trading cycle. This technique converts current receivables, inventory and payables to days to indicate the length of the average trading cycle. By dividing receivables by sales and multiplying the result by the number of days in the period covered by the statement (365 days for a year), the average days to collect receivables can be determined. Applying the same process to inventory and payables, using cost of goods sold rather than sales, provides the number of days inventory is held before sale and the number of days inventory is effectively being financed by trade suppliers. Again FIFO or LIFO inventory accounting will influence the calculations. Comparison of turnover numbers to similar firms or industry averages will indicate relative performance. Trends in turnovers are also more important than single numbers. Depreciable fixed assets also provide a cash cycle, usually over a much longer time frame. Cash expended for these assets is recovered over time through depreciation charged to expense that reduces profit but does not expend cash. To the extent earned, depreciation charges provide cash flow. In a stable economy the cash produced by earned depreciation can provide funds to pay debt incurred to acquire fixed assets or to purchase replacement assets as the original assets wear out. In an inflationary economy, replacement costs for fixed assets exceed the amounts recovered through depreciation, thus additional funds from profits or other sources are required for replacements. Utilization of fixed assets can be evaluated by the following ratios: Fixed Assets/Sales Fixed Assets/Equity Fixed Assets/Net Profit It is important to determine that fixed assets, either owned or leased, are adequate to support anticipated sales volume. As a general rule, the use of short-term debt to support acquisition of fixed assets indicates an unstable financial structure that will need to be corrected within a reasonable time frame. Two major concepts related to balance sheet structure are: Liquidity - the ability to get cash on a timely basis as needed. Leverage - the relationship of total liabilities to equity. Liquidity may be provided by having liquid assets readily convertible to cash or by the ability to borrow necessary funds on short notice. The more debt there is relative to the amount of equity, the higher the leverage. Conversely, the less debt there is relative to equity the lower the leverage. Traditionally, liquidity has been measured by the current, quick and trading ratios. However, these ratios deal with the magnitude of the current assets relative to current liabilities, not the quality of the current assets. To a large extent these measurements of liquidity assume liquidation. If the concern is to remain in operation, receivables and inventory cannot usually be reduced materially to reduce debt. Turnovers give some indication of receivable and inventory quality. Full evaluation of the quality of these assets requires receivable aging and details of the items making up the inventory. Cyclical or seasonal operations are difficult to analyze with only and annual statement. Typically, a business will choose a fiscal year end at the end of a specific cycle. For example, a department store may choose January 31, after a big sale, when inventory is at a low point before spring merchandise is stocked. An Auto dealer may choose September; just before new model year autos are included in inventory, when inventory is low. To properly evaluate trading assets, interim statements may be required to determine cash usage. Leverage is generally measured by the ratio - Total Liabilities/Tangible Equity. The higher the ratio the more leverage exists. Leverage can be used effectively to increase return on equity when the costs of borrowing are less than the earnings that can be obtained by employing additional assets. However, leverage is a two-edged sword and the earnings impact can be quite adverse if borrowing costs rise and exceed the earnings that the assets can produce. For any business, at any given moment in time, there is a maximum amount of leverage that can be supported. This maximum is a function of the cash flow available to service debt and the asset values available to support debt. Simplistically, the maximum leverage for a particular firm can be calculated by determining the maximum amount that an experienced, knowledgeable lender would lend on a secured basis against each individual asset. If the sum of these amounts is greater than the present total liabilities, there may be room for additional borrowings, if there is cash flow available to service all the debt. If the amount is less than the present total liabilities, the firm is probably over-leveraged and more debt will contain a higher than desirable degree of risk. Regardless of the level of debt that assets may support, the debt must be serviced. Consequently, cash flow from operations must be adequate to cover required interest and principal payments. When interest rates rise, a given level of cash slow will support less debt, due to the increased interest cost. Potential for rising interest rates increases the risk in highly leveraged situations. Stability of earnings and cash flow is a prerequisite to high leverage. Part One - Nature of Business Enterprise and Borrowing Purpose Part Three - Income Statement and Cash Flow Part Four - Definitions, Formulas and Loan Check List Ray Beaufait beau1943@beauproductions.com Top of Page |