Understanding Financial Statements When Approaching Lenders
by Jeff Schein
"The bank is asking for our financial statements", these are eight words that often bring
apprehension to many business owners. They are a young and maybe struggling company,
they need bank financing to survive, and they haven’t got a clue what the financial
statements are telling them, what they should be looking at, or what the bank wants
to see. Many will delay providing the required financial information to the bank, but
this is the worst thing you can do. Going to the bank shouldn’t bring on apprehension.
Having a basic understanding of financial statements and being prepared when you
approach a bank, or any investor, will go a long way in reducing your apprehension.
The Basics
The bank, or any investor for that matter, uses financial statements to tell them what
happened in the past. Statements are also used as a means to predict what will happen
in the future. Creditors are concerned about whether income (cash flow) will be
sufficient to cover interest and principal payments on their debt. Of course, predicting
profits into the future is an uncertain science. For this reason, creditors use various
analytical tools to help them assess and interpret key relationships and trends that
will help them judge the potential of success in the future. It also helps them predict
whether a firm has sufficient resources to handle a temporary financial crisis.
Financial statements are historical documents covering single time periods. Users of
financial statements, however, are not so much concerned about the single time period
as they are about the trends over time. Trend analysis is usually completed on key
indicators, such as revenues, gross profit margin, operating expenses, and working
capital components such as accounts receivable, accounts payable and inventory. Through
comparison of ratios and trends you can make informed judgments as to the significance
of results. That is why banks or other investors often want 2 or more years of business
results before they will lend.
Although trends and ratios are a starting point, they can often raise questions, the
answers to which you can only get through analyzing industry trends, economic factors
and the company itself. Typically, unless you are a master of presenting information,
bank lenders will ask questions of you and your business. This is normal as they are
trying to learn as much as possible about you and your business. Once again, be prepared,
this will show you understand your business and its finances and that will make the
bank more comfortable in lending to you.
The Balance Sheet
Banks primarily lend off the balance sheet and the cash flow statement (primarily
operational cash flow). That does no mean that the income statement is not important,
it is, but the balance sheet essentially encompasses what happens on the income
statement and the cash flow statement tells a lender whether you are actually generating
enough free cash flow from which you can make debt payments.
So what is important on the balance sheet?
Working capital
Current assets minus current liabilities, working capital tell us how much short-term
assets we have to pay off short-term liabilities. The greater the amount of working
capital the more funds a company has to finance its growth. A negative number is not
good and can signify pending trouble. A typical rule of thumb is a ratio of assets
over liabilities of 1.5:1. Questions you need to be able to answer are: trends in the
ratio, what are the components of the assets and liabilities and how liquid are the
current assets (for example, not all inventory can be liquidated quickly).
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