A borrower’s financial statements may look good, but they might not provide a full picture of the business’s financial health — in fact, they could be just the tip of the iceberg designed to lure you into a risky loan. It’s important to be aware that what’s undisclosed can be just as significant as the disclosures. Be alert for misrepresentations or failure to fully account for both assets and liabilities on the balance sheet, whether they’re merely unrecorded or deliberately hidden. What might lurk under the surface?
The search for undisclosed, hidden liabilities and risks starts with assets. For each asset, ask what could cause the account to diminish. For example, accounts receivable may include bad debts, or inventory may include damaged goods. In addition, some fixed assets may be broken or in desperate need of repairs and maintenance. These items compromise a borrower’s credit standing and affect its financial ratios just as much as unreported liabilities do.
Some of these problems may be uncovered by touring the company’s facilities or reviewing asset registers for slow-moving items. Benchmarking can also help.
For example, if receivables are growing much faster than sales, it could be a sign of aging, uncollectible accounts. Or if repairs and maintenance expense seems low compared to historic levels or industry norms, it could signal neglected upkeep on assets, which can be a costly gamble over the long run.
Next look at liabilities on the balance sheet and ask if the amount reported for each item seems accurate and complete. A company may try to understate its liabilities to appear stronger or to comply with its loan covenants.
For example, borrowers may forget to accrue liabilities for salary or vacation time. Some might underreport payables by holding checks for weeks (or months). This ploy preserves the checking account while giving bankers the impression that supplier invoices are being paid.
Other borrowers might hide bills in a drawer at year end to avoid recording the payable and the expense. This scam mismatches revenues and expenses, understates liabilities and artificially enhances profits. Delayed payments can also hurt the company’s credit score and cause suppliers to restrict their credit terms.
Finally, investigate what isn’t showing on the balance sheet. Examples include:
Such risks appear on the balance sheet only when they’re “reasonably estimable” and “more than likely” to be incurred. These are subjective standards. Some borrowers may claim liabilities are too unpredictable or remote to warrant disclosure. Footnotes, when available, may shed additional light on the nature and extent of these contingent liabilities.
Bankers also might consider the goodwill (or bad will) attributable to the company’s owners and top managers. Certain “key” people may be so instrumental to the business’s success that their unexpected departures could potentially expose the entity to financial hardship. Conversely, people who are risk-seeking, exceptionally tax averse or unethical put the company at risk for lawsuits, IRS inquiry, and insurance and warranty claims.
What can you do if you have unresolved questions regarding a borrower’s true financial status? Of course, in a full audit, a qualified, experienced auditor typically red-flags any hidden risks or potential liabilities. But if a full audit isn’t an option, you might want to specify a level of scrutiny that targets any unusual trends or anomalies.
You can then delve deeper to examine flagged areas of concern and address them with the accounting professional, working in tandem with the business’s financial officers to uncover any buried problems. This will help you gain a clearer picture of the company’s financial well-being.
For more information on Smith and Howard’s commercial banking services, please contact Paul Atkinson at 404-874-6244.
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