Do you know that financial reports are key documents that enable lenders to make a decision about whether they lend your business money?
You are probably aware of the 5 C’s that lenders look at when they assess an individual’s credit worthiness, namely: character, capacity, capital, collateral and conditions. In a similar way, lenders can tell from your business’ financial reports whether those criteria are met.
However, financial reports provide a lot deeper insight into assessing the risk the lender takes on when a business borrows money. So it stands to reason that if you want the best chance of borrowing success, then it pays to provide the lender with accurate, high quality information that is available in a timely manner.
It is also important to be prepared for the following questions:
- How much do you want to borrow?
- What time frame and how will it be repaid
- What is an alternative way the loan could be repaid should the business fail
- Is the loan application request reasonable in the circumstances
Like the 5 C’s of creditworthiness for an individual, there are 6 aspects to creditworthiness for a business that stem from financial reports. They are:
- Ratio Analysis
- Cash Flow
- Operation Risk Assessment
- Accuracy of Records
- Break Even Analysis
- Business Forecasting
The Ratio Analysis and what it reveals about your business
Well, actually there is more than one ratio. A lender may use four different ratios when assessing a lending application for a business.
- The Working Capital Ratio.(which is Current Assets / Current Liabilities) Working Capital represents a company’s ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since lenders can measure a company’s ability to pay off its debts within a year. Assessing the liquidity of a business, or how easily a company can convert assets into cash to pay its short term obligations, is crucial to the Working Capital Ratio. For example: if your company has assets of $10 million and liabilities of $5 million there is a straight forward ratio of 2:1 i.e. Current Assets / Current Liabilities. The lower the ratio, the longer it may take to pay back the lending or subject the borrower to undue stress on working capital.
- The Quick Ratio or ‘Acid Test’ Ratio. (which is Current Assets-Inventory/ Current Liabilities) This ratio shows how well current liabilities are covered by cash and by items with a ready cash value. Inventory, on the other hand, takes time to sell and convert into liquid assets. This ratio subtracts inventories from current assets, before dividing that figure into liabilities. For example: if your company has assets of $10 million less $3 million in inventory and $5 million in current liabilities the ratio is 1.4:1. Ideally, you want to show a 1:1 ratio, but if your business has less than that it could mean that you turn your inventory over quickly in which case the lender may seek clarification.
- The Debt-to-Equity Ratio. This ratio shows a potential lender if you are borrowing too much. The debt-to-equity (D/E) is calculated by adding outstanding long and short-term debt, and dividing it by the book value of shareholders’ equity. For example, your company has about $2 million worth of loans and has shareholders’ equity of $10 million. That works out to a modest ratio of 0.20, which is acceptable under most circumstances. However, like all other ratios, the metric has to be analysed in terms of industry norms and company-specific requirements.
- The Return on Equity Ratio. This ratio determines how valuable a shareholders investment in a company is. Return on equity is calculated by taking the company’s net earnings (after taxes), subtracting preferred dividends, and dividing the result by common equity dollars in the company. For example, if your company has net earnings of $1.5 million and preferred dividends are $500,000. Take that and divide it by the common equity of $8 million for arguments sake. That gives a ROE of 12.5%. The higher the ROE, the better the company is at generating profits.
The Importance of Cash Flow
You are probably aware that there are two forms of accounting that determine how cash flows within a business; accrual accounting and cash accounting.
Accrual accounting is used by most public companies and is the accounting method where revenue is reported as income when it’s earned rather than when the company receives payment. Expenses are also reported when incurred, even though no cash payments have been made.
Cash accounting is an accounting method in which payment receipts are recorded during the period they are received, and expenses are recorded in the period in which they are paid. Therefore, revenues and expenses are recorded when cash is received and paid, respectively.
From an accounting perspective, your company might be profitable, but if the receivables become past due or uncollected, your company could run into financial problems. Even profitable companies can fail to adequately manage their cash flow, which is why a cash flow statement is a critical tool for lenders to analyse.
How Operational Risk impacts a lender’s decision
Operational risk is the risk of loss resulting from ineffective or failed internal processes, people, systems, or external events that can disrupt the flow of business operations. The losses can be directly or indirectly financial.
Lenders view Operational risk as part of a potential chain reaction of events which may result in an organisational failure that can harm a company’s bottom line and reputation.
As part of this process, a lender may ask you to provide a summary of the following:
- Any breaches of private data resulting from cybersecurity attacks that have occured
- Technology risks tied to automation, robotics, and artificial intelligence
- Business processes and control weaknesses
- Physical events that can disrupt the business, such as natural disasters and health pandemics for example
- Circumstances of Internal and external fraud
Why your business must have accurate Financial reports
Having reports is critical for your business for a range of reasons, including preparing accounts, evaluating tax liabilities, decision making, planning, forecasting and borrowing money.
The many financial reports that must be prepared for your business, provide you with the information needed to establish your business strategy, make management decisions, and understand whether your business is facing a challenge or an opportunity.
Lenders rely on you as the business owner to provide them with accurate financial information. The documents they will request from you are:
- Statement of Financial Position
- Statement of Profit and Loss
- Statement of Changes in Equity
- Statement of Cash Flows
- Statement of Balance Sheet
- Any notes to the financial statements
In addition to the above, lenders may ask for supplementary information that gives a narrative to explain the businesses performance and financial position. Narrative may also be sought for information on business strategies, and prospects for future financial years.
The quality and accuracy of the information you provide a lender supports your case for funding. But not only that, it is a best practice standard to adhere to. And by following best practices, if the time comes that you want to exit your business then it makes the process of compiling your Selling Memorandum that much easier.
What is your Break-Even Analysis?
Break-even analysis involves calculating and examining the margin of safety for a business based on the revenues collected and associated costs.
In other words, the analysis shows how many sales it takes to pay for the cost of doing business.
Let’s say that your fixed costs are $3.5 million and your gross margin is 55%. Divide the fixed costs by the gross-margin. This gives us a break-even point of $6.3 million. This determines that your minimum weekly sales requirement is $131,250, based on a 48 week sales funnel
How accurate is your Business Forecasting?
Like any forecast, business forecasting involves making informed views based on modelling.
In the case of a business, the forecasting will involve metrics, regardless of whether they reflect the specifics of a business, such as sales growth, or predictions for the economy as a whole.
Financial and operational decisions are made based on economic conditions and how the future looks taking into account a degree of uncertainty.
A lender may look at how accurate your past forecasting has been and whether you have used qualitative and/or quantitative methods to make your assumptions.
So there you have it, 6 things a lender will look at before they will lend you money and how you can demonstrate your businesses creditworthiness.
- Constantly monitor your financial ratios
- Understand your cash flow and the impact it has on your business
- Know your operational risk factors and how to mitigate them
- Demonstrate Best Practice Standards by having up-to-date accurate information
- Know your break even point
- Use qualitative and quantitative methods in your forecasting
Get in touch
If you are confused by accounting and not confident that your financial records will stand up to the scrutiny of a lender, then get in contact with us today via email to organise a free no obligation chat. Also, if you need an accountant in Auckland – feel free to reach out. We will listen and then formulate the best strategies to help you achieve your goals. Alternatively, click on the Book A Call button now to get started.
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