Learning the Language of Money – An Owners Guide to Dealing with Banks, Part 3 of 6

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Learning the Language of Money – An Owners Guide to Dealing with Banks
A Five Part Series

Part 3 - Understanding Credit Analysis - I
Introduction

This is part three of our six part series. (Note: As we wrote this section, it became apparent that the subject was too long too fit into a single e-letter. Therefore we took the liberty of breaking it into two sections and expanding the total series to six segments). In part one, we discussed the nature of banks and bankers and how that affects the way they look at business owners seeking loans. In part two, we discussed the overall methodology banks use to evaluate you for the purpose of making a decision on a loan request. In this segment we will delve deeper into one of the critical portions of this methodology, Credit Analysis.

(Disclaimer: The topic in this segment, credit analysis and evaluation, has entire courses written about it. This article provides basic principles only.)

Acknowledgement – The Podolny Group would like to thank Doug Hall, Wells Fargo Bank, Los Angeles, for taking the time to review and provide comments on this series.


Defining Credit Analysis
Credit is a term for providing funds to someone. If you sell something and tell the purchaser they have 30 days to pay, you have advanced credit to the purchaser. Banks advance credit (provide funds) as a business. Each decision to do so is considered a “credit decision”. In order to make each decision bankers analyze the companies to which they lend money. This process is the “Credit Analysis”.

Evaluative Principles Affecting Credit Analysis
There are two evaluative principles which lie at the core of Credit Analysis:

  1. Financial reporting provides a reasonable understanding of what is going on in a business.
  2. What has happened in the past is a good predictor of what will happen in the future.

The study of financial reporting documents (Financial Statements) provides the base data used in Credit Analysis. Each document (as we will see) has information that represents different aspects of a business. By studying these documents along with other information on the potential borrower, a loan officer can get a reasonable picture of what is going on in a business.

When looking at this information, a loan officer is not just interested in a single data point. He or she wants to know what has happened over a period of time - usually three to five years. They want to see if the data is consistent and what kinds of trends are taking place. Inconsistent data or data trending in adverse directions will have a significant negative impact on the credit decision.

Any one seeking bank financing should never underestimate the importance of financial reporting when it comes to being assessed for financing! Loan requests succeed or fail due as much to the quality and dependability of financial statements as to the data in them.

The Three Questions:

  • Is the borrower making a profit?
  • How strong is the borrower?
  • Where is the cash going?

Each of these questions tells a lender important information on a borrower’s ability to repay a loan. Each ties into a specific part of the financial statements.

The Income Statement (also called the Statement of Profit and Loss) shows how well a company is operating and whether the company is making a profit. The Balance Sheet provides information on the company’s overall financial strength. The Statement of Cash Flows documents where the the business’ cash is coming from and where it is going. An analysis of a company’s Trade Cycle will show how much cash is needed to sustain operations and the effect on cash from changes in payments and collections. Finally, an Ability to Pay evaluation specifically analyzes whether a company can return the money being borrowed.

Income Statement
The Income Statement is like a moving picture (analogy thanks to Brad Steward, Pulakos and Alongi, Albuquerque). It records business activity over a period of time (a month, a year, etc.). It provides measurements of key business operating activities. These are:

  • The total of goods or services provided (Sales)
  • What it costs to produce Sales (Cost of Goods Sold)
  • What is left after paying to produce Sales (Gross Profit or Gross Margin)
  • Costs that cannot be specifically allocated to the product or service sold (Operating Expenses or Sales, General and Administrative Expenses)
  • What’s left after both direct expenses to produce and non-direct expenses (Operating Income)
  • Any other things bringing in revenue or that must be paid for (Other Income and Expenses)
  • And finally what is left before and after taxes (Income or Profit before and after Taxes)

These taken together tell how well a business is performing. The better a business performs the more money or profit it makes. Lenders will look at performance in terms of absolute numbers and in terms relative to a business’ peers.

Balance Sheet
The Balance Sheet is like a snapshot. It shows the overall condition of a business at any moment in time. Comparing snapshots provides indicators of consistency or change. The Balance Sheet has a listing of Assets which includes everything the company owns and uses to produce Sales. It lists all the ways the company has paid for those Assets, either Liabilities (other people’s money) or Shareholder Equity or Net Worth (owner’s money). Assets must always equal the total of Liabilities and Shareholders Equity.

Here is a quick definition of various Balance Sheet Terms.

  • Current – Anything that comes due or will be received in a year’s time. There are both Current Assets and Current Liabilities
  • Current Assets – The big four are Cash, Accounts Receivable, Inventory and Prepaid Expense
  • Current Liabilities – The big four are Accounts Payable, Accrued Liabilities, Bank Lines of Credit, and Current Maturities of Long-Term Debt (the portion of a long term loan due within a year’s time)
  • Fixed Assets – Any tangible asset with a lifetime over a year such as land, building, machinery, equipment, or leasehold improvements. These are reduced by their Depreciation which relates to the lifetime of that asset.
  • Intangible Assets – Any non-tangible asset with a lifetime over a year such as Goodwill, Covenants not to Compete, Patents, etc. These are reduced by Amortization which also relates to their lifetime as assets.
  • Long-Term Liabilities – Usually long-term loans
  • Paid-in Capital – Owner’s money put into a business
  • Retained Earnings – Profits from the business that are kept in it to be used as capital

Key Balance Sheet Related Principles
Most business owners have a reasonable understanding of Income Statement principles but a much looser grasp of Balance Sheet principles. There are two key Balance Sheet principles.

Leverage – This is the measure of what portion of Assets are being paid by others versus the owners. It is measured by a ratio called the Debt to Worth ratio. That ratio is calculated by dividing Total Liabilities by Shareholder Equity. If the ratio is 1 or under, the company is considered not-leveraged. If it is over 1, it is leveraged. The more leverage there is the more risk that is implied. (Note – all financial measurement numbers need to be taken in the context of the industry of the business. Different industries have different standards. One should go to a resource that can provide overall industry data such as the Risk Management Association [www.rmahq.org – Studies and E-tools] to compare any specific company’s information. By the way, RMA numbers are frequently used by lenders as the reference against which to measure a borrower. So knowing your industry’s RMA numbers is never a bad idea.)

Liquidity – This measures how flexible a company is if it needs to raise cash quickly. It is usually measured by two ratios, the Current Ratio (Current Assets divided by Current Liabilities) and the Quick Ratio (Cash and Receivables divided by Current Liabilities). A company is considered reasonably liquid if its Current Ratio is 2 or more.

In or next issue, Volume 8 Issue 1, we will continue to discuss Credit Analysis and define the Statement of Cash Flows, Trade Cycle, and Ability to Pay.

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Owners are advised to consistently compare their business goal requirements against their personal goal time frames. Downloading our free book, Make Your Business Serve You©, provides a methodology for conducting such a review.