When you begin to analyze a potential borrower’s loan worthiness, you know better than to skim the surface. Plunge in to see the full situation and truly understand your customer’s financial health.
Sharpen your focus
Start the due diligence process as an auditor would. That is, before you open a borrower’s financial statements, consider documenting the risks in the borrower’s industry, applicable economic conditions, sources of collateral and the borrower’s business operations.
This risk assessment identifies what’s most relevant and where your greatest exposure lies, what trends you expect in this year’s financials, and which bank products the customer might need. Risk assessments save time because you’re targeting due diligence on what matters most.
Review financials in context
Now tackle the financial statements, keeping in mind your risk assessment. First evaluate the reliability of the financial information. If it’s prepared by an in-house bookkeeper or accountant, consider his or her skill level and whether the statements conform to Generally Accepted Accounting Principles. If statements are CPA-prepared, consider the level of assurance: compilation, review or audit.
Comprehensive statements include a balance sheet, income statement, statement of cash flows and footnote disclosures. Make sure the balance sheet “balances” — that is, assets equal liabilities plus equity. You’d be surprised how often internally prepared financial statements are out of balance.
Statements that compare two (or more) years of financial performance are ideal. If they’re not comparative, pull out last year’s statements. Then, note any major swings in assets, liabilities or capital. Better yet, enter the data into a spreadsheet and highlight changes greater than 10% and $10,000 (a common materiality rule of thumb accountants use for private firms). You should also highlight changes that failed to meet the trends you identified in your risk assessment. For example, you expected something to change more than 10% but it did not.
Now ask yourself whether these changes make sense based on your preliminary risk assessment. Brainstorm possible explanations before asking the borrower. This allows you to apply professional skepticism when you hear borrowers’ explanations.
Devise a scorecard
Use your risk assessment to create a scorecard for each borrower. It often helps to discuss your risk assessment with co-workers and to specialize in an industry niche.
One ratio that belongs on every scorecard is profit margin (net income / sales). Every lender wants to know whether borrowers are making money. But a profitability analysis shouldn’t stop at the top and bottom of the income statement. It’s useful to look at individual line items, such as returns, rent, payroll, owners compensation, travel and entertainment, interest and depreciation expense. This data can provide reams of information on your client’s financial health.
Other useful metrics include:
- Current ratio (current assets / current liabilities). This measures short-term liquidity or whether a company’s current assets (including cash, receivables and inventory) are sufficient to cover its current obligations (accrued expenses, payables, current debt maturities). High liquidity provides breathing room in volatile markets.
- Total asset turnover (sales / total assets). This efficiency metric tells how many dollars in sales a borrower generates from each dollar invested in assets. Again, more in-depth analysis — for example, receivables aging or inventory turnover — is necessary to better understand potential weaknesses and risks.
- Interest coverage ratio (earnings before interest and taxes / interest expense). This calculation provides a snapshot of a company’s ability to pay interest charges. The higher a borrower’s interest coverage ratio is, the better positioned it is to weather financial storms.
When applying these metrics, compare a company to itself over time and benchmark it against competitors, if possible. If customers’ explanations don’t make sense, consider recommending that they hire a CPA to perform an agreed-upon-procedures engagement, targeting specific high-risk areas.
As experience has shown, lenders who only view the surface of a borrower’s financial condition can easily be misled. Use available tools to perform due diligence thoroughly.