A burning accounting question, answered: “Why do banks need financial statements?”
As a business owner, you understand the role financial statements play in providing an objective, quantifiable sense of "how" your business is performing and its overall financial position. After all, the "numbers" should “work” for you. Don’t let these reports “sit on a shelf.”
Financial statements are beneficial as more than drivers of strategic decision-making or sources of business intelligence. Perhaps, you have sought to reduce your reliance on credit cards. Maybe now (more than ever), you need the financial support to make the necessary investments to adapt to today's changing environment or get off the high-interest debt merry-go-round that isn't sustainable in the present challenging climate. In turn, you've arrived at low-interest business loans as a more attractive proposition; however, bankers, creditors, lenders, and like sorts also need to have an accurate picture of the "numbers." A vital vehicle to clarify your business's financial picture and overall creditworthiness is, you guessed it, the financial statement.
You want to knock off the lending party's socks. You'll need to ensure the following aspects of the financial statement are the picture of rosy health. Creditors will generally review income, total debt, expenses, profit, and cash flow. And more importantly, they'll scrutinize how these performance indicators interface with each other. By looking at the relationships between these metrics, financial institutions may be instilled with a sense of confidence. They'll have peace of mind that you can take on the additional debt obligation in the form of a loan or line of credit.
Ratio of assets to liabilities
Banks want to know what your assets look like concerning your business's liabilities. This information should be "current," that is, 12 months out, not 12 months past or 18 months on the horizon. They want to see timely information that conveys the nearer-term condition of your business. Assets include:
Cash on hand
Short-term portion of loans or credits payable
If your current assets exceed your current liabilities by 20%, that's a current ratio of 1.2. Generally, ratios of at least 1.2 are acceptable from a loan-worthiness standpoint. After all, this ratio illustrates how "liquid" you are and the ease with which these assets could be converted into ready cash. For the bank, this provides confidence that you’ll be able to repay – and repay quickly.
Ratio of equity to debt
Bankers will hover over the relationship between shareholder equity and the total debt that has been used to finance the business’s assets. This number tells your financial institution partner that you’ll be able to successfully take on the additional debt load and pay it off. Historical precedent is on the lender’s side here because this calculation pulls back the curtain on how your organization has used debt in the past.
The financial statements can scream "reliable" and "responsible" just as quickly as they can illustrate "recklessness" or "risky," the organization that tends to get in over its metaphorical head. There are some nuances from industry-to-industry or niche-to-niche regarding how this indicator is evaluated; for instance, if a manufacturing company is overleveraged, it could set off alarm bells. The question becomes, "Why are you carrying on so much debt, given the product or service that you offer?"
Likewise, if a company is in “growth mode,” being overleveraged may be justifiable. Why is it justified in this situation? You are taking on that debt to pay for the investments needed to expand or evolve in a competitive environment. The ends more than justify the means in this case.
Vehicles to satisfy the loan
Naturally, lenders are also looking for clues as to how your business will satisfy its loan obligations. These sources of repayment would primarily include cash flow. If cash comes up short as it relates to fulfilling the debt, rest assured your lender will be looking for other ways that you'll be able to pay and bridge the gap between the additional debt load and cash on hand. Savvy bankers have an eagle-eye on trends within your "space," on debts that are being paid down, and other obligations that are winding down, as well as on anomalies such as major one-time expenses that have affected cash flow. These and myriad other factors help to estimate future cash flow and the likelihood that you'll be able to pay down the debt in a timely fashion.
As a startup or rapidly expanding organization, you may be antsy about that ‘old trope of "cash is king." Never fear! Lenders will also be looking for secondary sources of repayment. Collateral could include property that is owned by the business, as well as equipment, receivables, and inventory. This, again, provides peace of mind to lenders that they’ll be able to satisfy the debt by liquidating these investments.
A word on covenants
Think of covenants as stipulations or provisions associated with your loan. Even after the loan has been awarded to you, favorable conditions must be maintained (including the likes of minimum or threshold ratios). Specific conditions will be spelled out in the language of your loan. The covenant typically requires that an audit be performed, and the audited financial statement be provided within a specified timeframe; for instance, four months after year-end. Again, this provides an independent audit or independent look at the current ratio. After all, it's one thing to have a client say, "My ratio is 1.3." It's quite another to have an objective; outside professionals confirm that the ratio is, indeed, 1.3. This provides a meaningful "check" for the bank as it evaluates the risk they're taking on by partnering with you. If you fail to maintain these standards, the loan can be recalled.
Banks and other lending institutions will also request financial statements when you enter into leasing arrangements; for instance, you may need to lease a piece of equipment. Akin to the loan process, lenders must determine your "lease-worthiness" – can you afford the payments? Likewise, to earn grants, hardship relief, and other funding types might require the likes of YoY cash flow or "reduction in business" information as part of the application process. This data would then be accounted for when determining your funding eligibility and the amount of funding that may be rewarded to you. Stipulations vary considerably from granting body to granting body and program to program.
Put your best financial face forward. Contact O’Donnell, Ficenec, Wills & Ferdig at ofwf.com to prepare your financial statements. So, you’re in the best shape to get the capital you need to grow your business or to modernize in a furiously-evolving environment.