Sep 27, 2010 –
Your financial statements may not make the bestseller list, but they do tell an intriguing story—at least to a banker. Unfortunately, the tale they tell may be misleading. Since finance is no place for fiction, you need to make sure your statements tell the truth, the whole truth, and nothing but the truth.
To do that, the first thing you need to know is that lenders read an abridged version of your balance sheet and income statement. Their credit department crunches your numbers to generate key ratios that make it easy to quickly assess your financial health. The more you understand about the ratios they care about and how they’re derived, the better you’ll be at making the story they tell a good one.
You’ve no doubt heard the phrase “garbage in, garbage out.” If the numbers on your year-end balance sheet and income statement aren’t representative of your real financial situation—which can happen for a variety of reasons that follow—the ratios that are based on those numbers will be rubbish and the story they tell will be incorrect.
Here are some of the common business situations that can distort your financial statements and potentially lead your reader astray.
Balance Sheet Lies
Your Balance Sheet offers a snapshot of what you own (assets) and what you owe (liabilities) on a certain date. Just like a photo in a book, it represents an instant in time. How you looked the moment it was taken is immortalized, but what happened before and after is a mystery.
That means that unusual year-end transactions can paint the wrong picture, and because year-to-year trends are almost as important as the numbers themselves, it’s one you’ll be stuck with for a long time. Here are some of the more common problems:
1. Large year-end purchases
While that close-out sale your supplier offered was a good deal financially, it will inflate both your inventory and your accounts payable.
When your lender runs your inventory and payables ratios and compares them to those of prior years and what’s typical in your industry, they’ll look out of whack. Without knowing about the year-end event, they might worry about a business slowdown, poor inventory management, or stale inventory (and, therefore, questionable collateral value).
2. Large year-end sales
If you have an unusually large sale at year-end, that will inflate your Accounts Receivable and suggest poor receivable management, uncollectable accounts, or an industry downturn—all of which might cause a lender to question the collateral value of that asset.
3. Extended payment terms from your supplier
Say your biggest supplier decides to offer extended payment terms for October and November purchases. If you take advantage of the opportunity, that will bloat your year-end Accounts Payable. To a lender, that will raise two red flags.
First, it will suggest a cash flow problem because if current liabilities (accounts payable and short term debt) are greater than current assets (cash, accounts receivable, and inventory), you won’t have enough cash to cover your bills.
Second, it could indicate that you’re not paying your bills on time—something that’s often an indication of bigger problems.
4. Off-balance sheet assets
If you hold business assets in a separate entity (such as a real estate partnership), this will reduce the ratio of what you owe to what you own. Known as the Debt to Worth (or Equity) ratio, lenders get nervous if this ratio gets too large.
5. Friendly debt
Unless loans from owners or others who’d be willing to take a back seat to a bank loan (called a subordination) are noted, they’ll hurt your Debt to Worth ratio.
6. Highly depreciated assets
If your balance sheet contains assets that are fully or highly depreciated—yet still valuable—the Debt to Worth ratio will look worse than it is. Be sure to note the market value of any assets that are worth more than their balance sheet value. By the way, don’t waste money on an actual appraisal. If the bank requires one, they have to order and pay for it themselves.
Your income statement can tell the wrong story too. We won’t even talk about under-reporting income except to say, “don’t.” However, there are legitimate factors that can make you look less profitable or more risky than you really are, such as:
7. A big contract or unusually large sale
You would think that landing a big fat contract would please your lender, but that’s not always the case.
First, unusually large contracts can be risky. There’s the risk that you may not perform. There’s the risk that the expenses you take on to fulfill the contract won’t be easy to shed once it’s completed. There’s a payment risk—a behemoth customer you can’t afford to fight might string you along or default altogether. There’s the risk that you get so overwhelmed with this contract that you neglect your other customers. There’s the pricing risk—eager to beat out the competition, small businesses often under-price their work. There’s the risk of the unknown, especially in fixed price contracts.
Second, absent a similar project next year, your numbers will appear to be on a downward trend. Remember, trends matter almost as much as the numbers themselves and lenders like trends to be stable or improving. This is not to say you should avoid unusually large sales. You just need to be sure your lender understands the resulting decline in revenue that occurs in subsequent years.
8. One-time expenses
One-time expenses (for an office renovation, product development, temporary hire, etc.) will raise concerns about cost containment and sustainability and may cause your profit margins to compare unfavorably with industry peers.
9. A change in accounting methods
A change from the cash to accrual method of accounting will obviously have a big affect in the year the change occurs, but even small changes matter.
Let’s say your administrative assistant moves into a commission-based sales position. His salary becomes a direct expense rather than an indirect one. That will lower your gross profit margin and even though your bottom line hasn’t changed, it will suggest the start of a downward spiral in profitability.
10. Owner perks
Discretionary expenses and owner perks obviously reduce profits. Be sure they’re disclosed in the financial statements. The bank will be happier if they know you could forgo them if times get tough.
11. A change in your sales mix
The addition of products with lower profit margins or a one-time sale at lower margins will cause your lender to suspect that you’re buying market share, unsustainably lowering your prices, or facing heavy competition.
12. A bad year
While a bad year will obviously concern a lender, if you’ve taken steps to fix whatever caused the problem, it’s important that you show them what you’ve done. For example, if you cut back on expenses or started selling higher-margin items at mid-year, you might want to prepare an income statement showing the full year effect of those changes.
What Your Banker Wants To See
So what the heck does your lender want to see in terms of financial ratios? According to Brett Mansfield, Senior Vice President of Business Banking for Union Bank, ratio expectations differ by industry, the size of the business, and other factors, but in general, here are the benchmarks he and other lenders look for:
Current Ratio: 1.5 to 1 or higher
Quick Ratio: 1 to 1 or higher
Debt to Worth: 3 or 4 to 1 or lower
Cash Coverage: 1.5 to 1 or higher
Performance Ratios (Gross Profit Margin, Operating Expense Margin, Net Profit Margin) should be consistent with your history and others in your industry
Accounts/Receivable (A/R) Turnover Ratios should be consistent A/R terms
Inventory Turnover ratios should be consistent with your history and others in your industry
A/P Turnover should be consistent with your payment terms
Mansfield notes too that ratio expectations aren’t hard and fast. “Weakness in one area may be offset by other strengths.”
It’s your job as a business owner to make sure your numbers tell the right story and if they don’t, the solution in most cases is fairly easy. You just need to explain anything unusual in the notes section of your year-end statements to clear up any potential flaws in the plot.
For more information on how to calculate key financial ratios and what they mean, check out this earlier post, Read Your Financial Statements Like a Banker.
Over the past thirty years, Kate Lister has owned and operated several successful businesses and arranged financing for hundreds of others. She’s co-authored three business books including Undress For Success—The Naked Truth About Making Money at Home (Wiley, 2009) and Finding Money—The Small Business Guide to Financing (2010). Her blogs include Finding Money Advice and Undress4Success.