Learning the Language of Money – An Owners Guide to Dealing with Banks
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
Evaluative Principles Affecting Credit Analysis
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:
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.
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.
Here is a quick definition of various Balance Sheet Terms.
Key Balance Sheet Related 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.
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.