A businessperson making a first-time loan application has greater reporting responsibilities and requirements than does a borrower who has been dealing on a continuing basis with a bank for short term financing. Once a bank has had good experience with a borrower, a loan request is much simpler. Usually the borrower need only provide updated information for an application that is on file.
Bankers are also interested in information that is not always reflected in the financial statements. For example, they like to be informed about the borrower’s management capability, organizational strength, experience, and reputation. However, in addition to this reputation information, the bank generally will require completion of certain standardized reporting forms in order to evaluate the creditworthiness of the borrower. Some of these filing requirements will be discussed next.
Projected Cash Flow Statements
One of the most effective tools to determine the amount of the loan needed and its repayment date is the projected cash flow statement. The projections should disclose the significant assumptions used by management in preparing the cash forecast. Generally, past performance will serve as the basis for preparation, but it should be adjusted to reflect current trends. Two ways of making these adjustments are (1) pro forma and (2) an attrition allowance. Pro forma adjustments reflect changes in a company’s projected cash flow that are nonrecurring; an attrition adjustment can be used to reflect recurring changes and expenses. For example, if the company has an agreement with labor for an annual increase of 7 percent, this would be treated as an additional allowance and grouped together with other recurring costs as an overall percentage adjustment to expenses. Nonrecurring expenses can be treated as one-item adjustments to individual expenses. An example of a typical nonrecurring item may be the payment of damages due to a loss in a personal injury lawsuit. It is not anticipated that in any succeeding period the company will lose a similar lawsuit. If it does, it should be treated as an attrition allowance.
The cash flow statement should show a monthly estimate of receipts from all sources, such as cash sales, accounts receivable, miscellaneous income, and loans. The estimated expenditures should include capital improvement, accounts payable, taxes, payroll, other operating expenses, and repayment of loans.
When bankers look at a company’s financial results, they are concerned not only with cash flow but also with other financial trends. The question may not be what the ratios are for the year, but rather how they compare with those of the previous years. The question that will be asked is: How does your financial picture (past, present, and projected) relate to the general economy and to the borrower’s industry? Banks generally keep a record of clients’ financial trends by periodically transcribing all of the vital balance sheet and operating statistics to a worksheet.
Banks may calculate some of these key financial factors:
- Net working capital
- Working capital or current ratio
- Net quick ratio
- Ratio of debt to net worth
- Number of days of sales in accounts receivable
- Number of days of purchases in accounts payable
- Number of days of supply of inventory (related to cost of sales)
These are discussed in my other post, but the relevant ones (in term with bank loan) are defined and briefly discussed here.
Profitability is a measure of how well the business has been doing. At least three ratios generate meaningful potential measures of a firm’s profitability:
- Net profit to net sales
- Gross profit to sales
- Net profit to net worth
It is important that a company be able to earn profits in a manner consistent with the capital invested and the expected growth. When the company shows that it has a high net profit, not only does it have debt-paying dollars, but it also has fresh capital to reinvest and support its own growth. These are indications of good management. A bank will be interested in looking at year-to-year profitability and noting any trends in ratios.
Bankers will also want to see if the company’s flow of net profits into its working capital is growing. They will be interested in whether profits must be reinvested constantly in fixed assets. Also, a company that pays out all of its profits in dividends and salaries will be unable to show growth in net worth from this source.
Bankers usually will add back noncash items, such as depreciation, to the net profit of the company to arrive at the cash flow or debt-servicing dollars available from profit. Caution must be emphasized here, for what the bank might be doing is looking to funds that are earmarked as a “reserve” for equipment replacement. Although the bank may be interested in the potential use of those funds for debt servicing in the worst case, enlightened bankers will also care about replacement of worn-out assets. The best bankers are concerned with the long-term needs of the business as well as protecting their own interests.
Net Working Capital
The net working capital of the company is defined as the excess of the current assets over the current liabilities and is a significant factor to be considered for credit purposes. A bank expects a company to provide enough of its own normal working capital to carry its inventory, accounts receivable, and other current assets at prudent levels. The company should be able to meet these obligations during nonpeak sales periods of the year. Thus, even during slow times, the bank expects the company to cover its current liabilities within the customary terms of trade.
Working Capital or Current Ratio
This is the ratio of current assets to current liabilities. It is even more significant in the bank’s appraisal than in the working capital budget. For example, company A has current assets of $200,000, current liabilities of $100,000, and net working capital of $100,000. The working capital ratio is $200,000 to $100,000, or 2 to 1. Company B has current assets of $500,000, current liabilities of $400,000, and net working capital of $100,000. The working capital ratio is $500,000 to $400,000, or 1.25 to 1. Both firms show the same net working capital of $100,000, yet the first company is in a more favorable position because it has $2.00 in current assets from which to pay for each $1.00 in current liabilities in the event that it must liquidate assets. The second company has only a $1.25 to meet its current liabilities of $1.00. Therefore, based on this ratio, company A would be considered to be in a much stronger financial position.
Net Quick Ratio
Another indicator bankers use to determine the ability of a company to pay its bills is the net quick ratio. This ratio is determined by taking the total of cash, short-term marketable securities, and net receivables, and dividing it by the total of current liabilities. This is a simple measure of the firm’s liquidity or the company’s ability to pay its debts. Again, a bank will be more concerned with the trend established by several years of net quick ratios. This will show the bank whether the company is increasing or decreasing its liquidity and hence its ability to meet its debt. Since cash and accounts receivables are far more current than inventory, this ratio is a good indicator of the relative short-term liquidity risk of the company.
Ratio of Debt to Net Worth
Another test of the adequacy of the company’s net worth is the ratio of total debt, including current liabilities, to net worth. Banks, again, generally will rely on the trend in the ratio as well as the specific number itself.
Number of Days of Sales in Accounts Receivable
In calculating this number, these assumptions are made:
- An even flow of sales
- A uniformity in collecting accounts receivable
The question here is the average number of days it takes the company to collect its accounts as compared with other firms within the same industry. The banks will factor in the number of days normal for the terms of the sale and those of the industry. For example:
Assume a firm has average daily credit sales of $20,000 and accounts receivable are $1.8 million. The terms of the sale are 30 days. The first step is to divide the accounts receivable of $1.8 million by $20,000, the average daily credit sales. This indicates that 90 days of sales are still in accounts receivable and that the accounts receivable are taking longer to collect than the normal 30-day terms. In fact, on average, this company is collecting its accounts receivables 60 days after the expiration of the due date. This is 60 days more than the pricing policy allows; it is probably having considerable financial effects on cash flow.
This also indicates that management may not be doing a good job of managing its accounts receivable. However, this may also be typical for the industry. If this is your situation, you should take some steps to try to improve your accounts receivable collection policy. You are loaning money to your customers for an average of 60 days more than you intended when you set your terms of sale.
Number of Days of Purchases in Accounts Payable
This figure is computed by dividing the average daily purchases into the accounts payable. If, for example, the average daily purchases are $5,000 and the accounts payable are $150,000, the number of days purchases in accounts payable is 30 days. This number tells a banker quickly if the company is paying its bills promptly. Significant variations from normal trade terms must be explained. If the company is on a net 30-day cycle, then it is meeting its obligations and perhaps obtaining all of the discounts it is entitled to under the terms of its purchase agreements. That question requires further examination.
The ratio is helpful, but you should also be concerned with those accounts payable for which discounts were lost and not only the average payments. The company should be examining its aging of payables and monitoring discounts lost.
Number of Days of Supply of Inventory
This number is computed by dividing the cost of the inventory by the average daily cost of sales, assuming an even flow of sales. The answer gives the banker the average number of days it takes the company to turn over inventory. The abuse that the bank is looking for here is excess inventory. This ratio will vary substantially from business to business. Supermarkets generally have very short inventory cycles, whereas automobile dealers have longer cycles.
Other Supplemental Data Required
Other information that should be considered for submission in the loan request presentation includes:
- A summary of insurance coverage
- An analysis of profitability by product line, if available and applicable
- Unusual events, historical or prospective, affecting the company
- Concentration, if any, of sales within a small number of customers
This shows the bank the reliance on a few select customers. f sales are concentrated in very few buyers, as in the erospace industry, the risk associated with that industry may be considered to be somewhat higher.