Commercial Lending Report: Looking at Financials Differently
December 31, 2013
Before you give the green light for a business loan, you conduct due diligence. But if you only review past financial statements, you’re not seeing the full road ahead — and that road might be littered with hazards. Instead, consider tweaking your examination.
Assessing the risks
Start the process as an auditor would. That is, before you open a borrower’s financial statements, take a minute to think about the industry, economic conditions, sources of collateral and business operations.
This assessment identifies what’s most relevant and at risk, 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.
Being “in the know”
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 (GAAP). If statements are CPA-prepared, consider the level of assurance.
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, liability or capital. Better yet, enter the data into a spreadsheet and highlight any change greater than 10% and $10,000 (a common materiality rule of thumb accountants use for private firms).
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.
Using key metrics
Use your risk assessment to create a scorecard for each borrower and refer back to it from year to year. It often helps to discuss your risk assessment with co-workers and to specialize in an industry niche.
When evaluating these metrics, compare a company to itself over time and benchmark it against competitors, if possible. These scorecards provide a launching pad for borrower meetings. If customers’ explanations don’t make sense, consider requiring them to hire a CPA to perform an agreed-upon-procedures engagement, targeting specific high-risk areas.
Customizing your approach
No two borrowers are exactly the same. Customize your approach for different lines of business and niches that come with their own sets of risk, opportunities and likely sources of collateral.
Contact Smith and Howard’s Commercial Lending Team at 404-874-6244 and ask for the “Lender Hotline.” You’ll be directed to one of our professionals who can answer your questions.
If you have any questions and would like to connect with a team member please call 404-874-6244 or contact an advisor below.CONTACT AN ADVISOR
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