Borrowers often provide bankers with forecasts and budgets. It’s especially common when they’re asking for additional money to start or expand business operations — or when they’ve been experiencing financial distress. But how much can you trust estimates that are prepared in-house?
People inside a company often know the most about its direction and key objectives. But insiders also tend to be “married” to the company’s strategic plan. This exuberance may prevent them from seeing the plan’s flaws and weaknesses objectively. Moreover, some borrowers simply aren’t skilled at budgeting. Bankers can be the voice of reason, assessing whether the estimates seem reasonable and monitoring how the estimates compare to actual results.
Similar to a banker’s due diligence, management’s estimates start with historical financial statements. From there, management may simply apply an expected growth rate to annual revenues and let it flow through the remaining income statement and balance sheet items. For some companies, this simplified approach works well. But future performance can’t always be expected to mirror historical results.
For example, suppose a borrower is renegotiating contracts with its labor union or a major supplier. The new contracts may affect direct costs and profit margins over the coming year. To accurately reflect future earnings, management’s estimates would need to take these changes into account.
Another reason this approach may be oversimplified relates to depreciation expense: Management may presume that annual depreciation expense will reasonably approximate fixed asset purchases in the future. This assumption could be inaccurate for a variety of reasons.
For example, a small borrower that doesn’t provide financial statements that conform to U.S. Generally Accepted Accounting Principles could, instead, use tax depreciation schedules for its financial reporting. In that case, depreciation expense is likely to underestimate the need to invest in new fixed assets. This is especially true if the borrower recently took advantage of the expanded Section 179 and bonus depreciation deductions that allow companies to write off all or a large portion of fixed asset costs in the year they were purchased. Depreciation expense may be negligible for these assets in the years after they were initially bought (and written off).
In other situations, a borrower can’t maintain its current growth rate indefinitely without investing in additional assets or incurring additional fixed costs. For example, a company may be operating near full capacity, requiring it to build a new plant, purchase another piece of equipment, hire more workers or rent additional space to accommodate the expected growth in revenues over the long run. External and internal factors — such as regulatory changes, product obsolescence and in-process research and development — also may require specialized adjustments to the budget.
How do budgets measure up?
An effective way for you to gauge the reasonableness of management’s estimates is to ask for interim financials and then compare the results to what was previously budgeted. Is management on track to meet its estimates? If not, help management identify the cause and ask for a revised budget. Often, once the cause is unearthed, management can fix the problem and get back on track.
Some borrowers feel overwhelmed by preparing a complete set of financials each month. So, you might opt for short-term cash reports, which highlight the sources and uses of cash during the period. These cash forecasts can serve as an early warning system for “budget killers,” such as unexpected increases in direct costs or delinquent accounts.
Alternatively, many companies create 12-month rolling budgets — which typically mirror historical financial statements — and update them monthly to reflect the latest market conditions. Longer-term budgets are also useful, because they provide insight into the company’s strategic plan, especially for a start-up or a borrower that operates in a volatile or emerging industry niche.
How can bankers help?
When you receive forecasts and budgets, evaluate whether they seem reasonable. Then save the estimates to compare with actual results later on. By doing so, you may help borrowers catch problems before they spiral out of control.