Tips for Creating Organized Financial Statements
A few months ago, I wrote an article for Intuit’s blog about what banks are typically looking for when underwriting a business loan.
In the last QB PowerHour on 04/16/15, I went a step further and covered some of the specific items in a Financial Statement and other Financial Reports that lenders specifically evaluate when determining the risk associated with the loan. Watch the excerpt of the video here:
The most important takeaway is that instead of just printing the QuickBooks® reports as is, take the time to look into the specific order and organization in which these Financial Statements need to be presented, so that the bank can perform a fast and precise analysis of the financial health of the business.
For instance, the Income Statement (or Profit & Loss in QuickBooks) should be organized this way:
A particularly important area of focus is appropriately identifying Cost of Goods Sold (COGS) vs. Operating Expenses (Expenses), in order to make that there is proper analysis of GROSS PROFIT and GROSS MARGIN. Gross Margin percentage says a lot about a business. For example, if you have LOW gross margin percentages, such as 7%, you can infer (even without knowing anything about the business itself) that they are typically focused on volume sales, low priced and lower quality items, and mostly commodities, (Example: ExxonMobil). However, if the business has high profit margins, reaching over 40%, you can imply that the business has a mixture of services with products, and is focuses on a higher priced, higher quality product, such as Apple.
Ultimately, the “bottom line” is that they are interested in the NET PROFIT, which indicates that the business will have the ability to repay the loan.
Extraordinary and Non-Operating items should also be property identified; specially, if you had a particular year with a large loss that is not expected to be recurrent, the bank may consider excluding that from the NET PROFIT calculation
Then, there’s the Balance Sheet. It should be organized this way:
Banks are mostly focused on the Liquidity of the Business, which means the higher the amount of Current (or highly liquid) Assets, the better chance the bank has to recover their funds if the loan goes sour. Fixed assets sometimes serve as Collateral, where a particular equipment or real estate asset backs some loans. That’s illustrated below:
Most banks do not want to lend to businesses that are already with high debt because it could become difficult to pay back all those loans. The banks are very aware that a business may file bankruptcy, and in most cases, the owners do not give any liability to pay them back. So, this could be a red flag. The other potential issue is that if there are other banks that have lent the business before, they may have a BLANKET LIEN on the business, which means the new lender is in second position for collateral, resulting in a much lower probability of collecting that loan if it goes sour. Moreover, there is typically a domino effect; if one loan defaults, all default.
Equity, the NET WORTH of the business, is also very important. Equity is increased with Net Income (Retained Earnings) and Owner’s Capital. In other words, if the business owner(s) keep the profit inside the business, equity maintains and grows. However, if they distribute all the profits, equity stays stagnant or decreases.
The last piece I wanted to cover is “Credit Philosophy.” Most banks create simplified strategies for lending that make it easy to understand the guidelines or philosophies for measuring risk before issuing any credit. A great example of that is the “Five C’s of Credit,” shown below:
- Capacity: can the borrower repay the loan
- Capital: is the borrower invested into the business. Are they putting in a down payment (skin in the game)?
- Collateral: if the loans default, can the bank recover the capital with the collateral?
- Conditions: Is the industry in good shape? Are there regulatory or external factors affecting the borrower?
- Character: credit history and statistical risk.
This takes me to the conclusion of the article; the idea behind understanding these concepts is being able to PREPARE for the bank loan application process. Other than hiring a CPA to prepare these financial statements for the bank, the other most important thing a small business owner can do is prepare a “Narrative” in the form of a Business Memo or Business Plan that makes a strong case for why this business needs a loan, what the funds will be used for, how this cash flow injection increases sales and the bottom line, and lastly, a great explanation on how the ongoing operation affects all items on the financial statements. This is very similar to disclosure notes that are often prepared by a CPA during Audits.