Many business owners mistakenly believe that money in the bank account and good profits represent strong financial statements. Of course, showing a profit is a positive sign, but when assessing the strength of a business’ balance sheet, a bank will review a number of other indicators.
Financial statements will typically contain at a minimum: a balance sheet, profit and loss statement and cashflow.
The Balance Sheet
The balance sheet comprises three components: assets, liabilities and equity.
Cash in the bank account is not necessarily a significant positive to the bank. A bank account is highly liquid and can fluctuate from week to week. On the other hand, tangible, illiquid assets such as property or land create a very healthy balance sheet and are highly valued by banks.
- Stock (inventory) and debtors (accounts receivable) are assets that will often provide security to enable bank finance but, whilst the dollar value is important, the bank will look closely at the quality of the assets.
- Excessively outstanding debtors and unsecured loans to associates or related parties in the assets section will have minimal value, as they will most likely be viewed as uncollectible if the bank forecloses on the loan.
Basically, the fewer liabilities on your balance sheet the better:
- Debt in the balance sheet secured against specific assets usually means that these liabilities are effectively cancelling each other out.
- Large creditors (accounts payable), particularly those greater than thirty days or outside trading terms, will generally be viewed unfavourably.
- Banks will scrutinise all statutory obligations such as tax debt, superannuation, payroll tax and work cover to ensure they are up to date.
- Unsecured loans or related party loans in the liability section are viewed positively by the bank. These loans represent capital injected or profits left behind in the business and indicate that the business is fully or partially self-funded.
The greater equity the better. Equity or shareholders’ funds represent capital injected into the business and/or profit retained to fund and build assets. This will be viewed positively by the bank.
Negative equity would suggest that liabilities exceed assets and would be a cause for concern. In fact, unless the directors/shareholders or beneficiaries have subordinated loans under liabilities, this may be a significant concern for the solvency of the business.
When it comes to the balance sheet, strong cashflow and sustained profits are good indicators, but a bank will closely scrutinise the report. They will assess the business’ strength and the asset coverage of the funds lent to ensure that the business can repay the bank.
Profit and loss statement
Financial institutions will typically want a minimum of the last two-to-three years’ profit and loss.
Whilst strong profits are a good indicator, the bank will often delve deeper into what is behind the profit result. Firstly, they will look at the fundamentals of the profit and loss statement considering items such as rent and wages relative to business turnover.
Banks often use data on industry benchmarks to assess expenses and overheads relative to comparative businesses. They will inspect the business’ gross margin, closing stock figures, sales and turnover and compare them to industry standards and comparable businesses.
They will also view whether revenue has been increasing in order to understand if the business has been growing or contracting over the previous few years. Declining revenues will often require an explanation whilst rapidly increasing turnover will be important to the bank in understanding funding requirements for the business’ growth prospects.
For an owner operated business a financial institution will scrutinise the shareholders’ and/or directors’ full take home pay. It may be that profit is high but the directors are drawing minimal wages, or profit may be on the low side while owners are drawing large wages.
Typically the bank will look at the EBITD (earnings before interest, tax and depreciation) and add these outgoings to prior years’ profits to determine anticipated cashflow to repay a loan.
In understanding the future profits and the ability of a business to meet ongoing financing commitments, the bank will typically want 12-to-24 months of projected cashflows. The cashflow will demonstrate the direction in which the business is going, including growth expectations and cashflow requirements.
A typical funding facility will include long-term financing with a term loan or commercial bill but the bank will also generally provide a short-term facility such as an overdraft.
Importantly when preparing a cashflow you should demonstrate to the bank the ability to make interest payments and principal repayments if required. For example, if requesting an additional $2 million in funding, your cashflow should incorporate the additional interest payments required on this facility.
It is vitally important that the forecast be realistic. Businesses will often prepare extremely optimistic profit projections to gain favour with the bank, however the bank may turn to the business owner and say “based on this cash flow you do not need any money from us!” Be careful that you don’t outsmart yourself!
Obtaining business finance in the current economic environment is proving extremely difficult. Ensuring that your financial statements are in good order and showing the bank what they want to know will make a significant difference.