BUSINESS LENDING FINANCIAL SOLUTIONS Consulting Services 
Commercial Lending BasicsPart Four - Definitions, Formulas and Loan Check List PROFORMAS AND PROJECTIONS Even the most current financial statements do not reflect the current position of the enterprise. Statements take time to prepare, and even the most current is for a date in the past. Proforma statements are developed by adjusting historic statements, for known subsequent events. For example, the statement analyzed for a new loan does not contain the loan. It is relatively simple to create a proforma showing the proposed loan in the liabilities and making such other adjustments as necessary to reflect use of the loan proceeds. Conventional ratio analysis can be applied to the proforma to determine that the ratios remain as acceptable after the loan as they were before. Proforma statements also are used to see the impact of changes in sales mix, cost relationships, capital expenditures, debt refinancing, equity changes, or anything else that would impact the relationships in the income statement or balance sheet. Proforma statements also can be used to illustrate the seasonal expansion and contraction in trading assets and related short term financing. Projections of financial statements generally cover at least one year and may cover as many as ten years. Projections are attempts to show what the financial statements will look like bases on assumed sales volume, cost relationships, fixed asset requirements and the like. Projections are based on overt actions by management and cannot be evaluated without knowing the major assumptions used in their preparation. Projections that show substantially different asset or cost relationships than the historic financial statements need to be carefully scrutinized to make sure that the changed relationships are realistic. Although all projections are presented to potential lenders as being conservative, very few actually are. Most common projection errors include:
In spite of their inherent potential for inaccuracy, projections are uniformly useful as a tool in evaluating loan requests. Projections should be mandatory for most term loan request and are very useful for short-term loans as well. Projections need not be formal and prepared by an accountant. They can be informal and prepared by the lender in conversation with the borrower. Many projections on scratch paper are as valid as fancy computer printouts. However, the ability to make changes to assumptions to attempt to evaluate changes in sales levels, profit margins, interest rate levels and the like, make the computer a useful tool for determining the most sensitive areas in a forecast. One important element of good projections is the cash flow analysis. Using the funding requirement format illustrated earlier, a lender can easily determine the asset requirements for a particular situation and test to see that adequate cash will be available. In many cases a cash budget, reflecting cash timing rather that financial statement timing of transaction, is the most useful part of a set of projections. While income statement and balance ramifications of future business are important, the actual flow of cash is more critical as a source of loan repayment. LOAN STRUCTURE Once the loan request has been analyzed and the repayment source identified, the loan structure can be designed. Maturity and timing of payments should relate to the cash flow produced by the purpose of the loan. Protection of financial condition and control over utilization of cash flow can be obtained through a loan agreement. The covenants in the agreement establish the parameters within which the business can operate without causing discomfort or concern by the lender. Agreement covenants should be well thought out so that any violations are meaningful indicators of difficulty. Secondary sources of repayment can sometimes be obtained through co-makers or guarantors. In order for guarantees to be enforceable, there must be valid consideration for the guarantee. Generally this means there must be some economic benefit to the guarantor from the transaction. Collateral is a common secondary source of repayment. The borrower specifically assigns assets that may be liquidated if necessary to repay the loan. Collateral should never be the primary source of repayment. To serve as an acceptable secondary source or repayment, collateral must be marketable, often under adverse conditions. In addition to serving as a secondary source of repayment, collateral also can be taken to limit the borrowing capacity of the business. Assets pledged to one lender are not available to obtain borrowings from another. When the collateral taken is significantly more than required to support the debt incurred, it is important that the borrower understand how much additional borrowing power is available and for the lender to be willing to provide additional funding in the future. Taking all the assets of a borrower as collateral without being willing to provide additional supportable financing does not work to the advantage of either party to the loan. A proper lien position must be established and the lender needs to monitor the continued existence and value of collateral to be certain that it is available when needed. If trading assets (receivables and inventory) are being used as collateral, there needs to be some form of reporting to the lender to insure that the loan balance and the value of the collateral remain in an appropriate relationship. Pricing is an integral part of loan structure. In theory there are two elements in loan pricing. First, the return on the loan must cover the lender's costs and provide some profit. Second, the return should reflect the risk the lender is taking. No return can compensate fully for loss of principal, but more risky transactions should be priced to provide a higher return. The borrower's willingness to pay above a market price on a transaction may indicate that the risk is more than the lender cares to assume. Loan structure also includes the proper documentation to book the loan as a sound asset. This includes a properly executed note, appropriate disclosures as may be required under regulation, and such other documentation as may be required to perfect liens on any collateral. Getting the documentation in order before disbursing the loan insures that there will not be any documentation weaknesses. Once the borrower has received the funds there is little incentive to complete additional paperwork. There are usually three steps to a loan transaction:
The final element of loan structure is the program for loan management. This includes an adequate continuing flow of information so the lender can monitor performance and collateral coverage. A good flow of information will provide the lender with the information necessary to be able to anticipate and react appropriately to changing situations. Sound loans result from comprehensive analysis of the loan proposal coupled with an appropriate structure to enable the loan to be serviced within the capacity of the borrower. Sound loan management tracks an adequate flow of information and updates the original analysis to permit timely reaction to changing conditions to both protect the lender and provide optimum financial assistance to the borrower. The real challenge in lending money comes from the simple fact that the future rarely turns out exactly as expected. Ability to anticipate and react to changing conditions to maintain credit quality while providing service is the mark of the true professional. DEFINITIONS Breakeven Point - Level of sales necessary to cover all expenses with no profit. Current Assets - Assets that are expected to convert to cash within one year of the balance sheet date through normal business operations. Prepaid expenses and supplies are considered current assets under generally accepted accounting principles, but not usually for credit analysis. Current Liabilities - Liabilities that are payable within one year of the balance sheet date, including current maturities of term debt. Equity - Owners investment in a business to which profits and losses accrues. Evergreen Loan - A loan, which although revolving, cannot be paid without significant liquidation of the borrower's assets to the extent that normal operations could not continue. FIFO Inventory - A method of inventory valuation in which the first goods acquired are assumed to be the first goods sold. (First In, first out) Fiscal Statement - Financial statement covering a full business year. GAAP - Generally accepted accounting principles. Intangible Assets - Assets that are neither tangible property nor a direct right to tangible property, such as Goodwill, Patents, Trademarks, Licenses, etc. Interim Statement - Financial statement covering a period less than a full fiscal year. LIFO Inventory - A method of inventory valuation in which the most recently acquired goods are assumed to be the first sold. (Last in, first out) Liquidity - Ability to obtain cash as needed. Operating Leverage - Relationship of variable costs to net income. Proforma Statement - Existing financial statement adjusted for known and or anticipated subsequent changes. Subordinated Debt - Debt that by agreement has been subordinated in payment to bank or other debt. Tangible Equity - Book net worth less intangible assets. Trading Assets - -Accounts Receivable and Inventory. Trading Cycle - Period, usually stated in days, to obtain and sell inventory and collect receivables, reduced by period financed by trade payables. Working Capital - Current assets minus current liabilities. FORMULAS Ratios Current - Current Assets / Current Liabilities Quick - Current Assets - Inventory / Current Liabilities Trading - (Receivables + Inventory) / (Payables + Short Term Borrowings) Leverage - Total Liabilities / Net Worth Tangible Leverage - Total Liabilities / Tangible New Worth Sales to Assets - Sales / Total Assets Interest Coverage - Pre-tax Profit + Interest Expense / Interest Expense Percentages Gross Margin - Gross Profit / Sales Return on Sales - Net Profit / Sales Return on Equity - Net Profit / Net Worth Return on Assets - Net Profit / Total Assets Turnover (Days) Receivables - (Receivables / Sales ) X 365 Inventory - (Inventory /Cost of Sales) X 365 Payables - (Payables / Cost of Sales) X 365 SIGNIFICANT MEASURES OF BUSINESS PERFORMANCE
ANALYTICAL CHECK LIST While the appropriate degree and depth of evaluation and analysis will vary from credit to credit, comprehensive analysis will include all the following areas. Details of the proposal: - Purpose - Amount - Source and Timing of repayment - Secondary source of repayment Borrower's analysis: - Operating and industry characteristics - Management character and capacity - Quality and reliability of information - Operating performance - Volume trend - Profitability - Balance Sheet - Liquidity - Leverage - Asset Quality - Liability Structure - Liens - Cash flow - Funding requirements - Source of finds External Analysis - Prior credit record - Reputation in industry - Customer experience - Supplier experience - Competitive position - Environment Collateral Analysis (if needed) - Quality - Marketability - Value determination - Lien position - Process to manage Program for loan management - Loan structure - Flow of information - Borrower contact - Collateral (if applicable) - Agreement covenants (if applicable) Part One - Nature of Business Enterprise and Borrowing Purpose Part Two - Source of Loan Repayment and Analytical Process Part Three - Income Statement and Cash Flow Ray Beaufait beau1943@beauproductions.com Top of Page |