What is Important in Borrower Financial Reports

Borrower C&I Credit Analysis

It used to be a banker at a major bank you would go through a credit training program where you would spend weeks learning to tear apart a set of borrower financial statements. We can tell you from experience that it was too much. Unfortunately, these days, the pendulum has swung the other way and with the advent of credit spreading software such as CreditQuest we have almost made it too simple. For young bankers coming up through the ranks, consistent training is hard to come by, and fewer bankers understand what is important and what is not in credit analysis. There is a continuing reliance of just trying to plug in the right financial numbers so you can get a debt service coverage ratio and then just rely on that. We can tell you that it is not that simple. We know that, as for the past several years, we have been looked at over 500 credits that went bad during the downturn and asked the question – what information should we have known to take action earlier. In this article, we put that data to work and tell you the areas to focus on that would have covered more than 80% of all defaults.


Too Much Analysis – What is Not Important


Many a banker can remember how they used to spend a complete day on memorizing all the various asset depreciation methodologies and the rules for applying them.  This knowledge is fantastic if you are going to be an accountant, but looking back on all the defaults we can tell you that there were zero cases where understanding the different methodologies would have made any difference in preventing a delinquency. As a banker, this is a classic example of noise instead of signal.


The same can be said for the composition of goodwill, the endless footnotes in some financial statements and the disclaimers on publically traded companies that are either obvious or worthless. Bankers need to remember that if you are an accountant or a lawyer for a borrower, the more issues you try to disclose the less liability you have. For publically traded companies, for instance, regulatory disclosures are now five times larger than they used to be ten years ago. We love when a company discloses that they are at risk of changing market conditions and from competition – no kidding. 


Further, often all financial information and disclosure are weighted equally, and it makes it harder, not easier to determine what is really important to determine the probability that you will get paid back your principal.


What Is Important


Going through a financial statement of a potential borrower starts with focus. If you don’t have specific questions in mind that you need to answer, then you are going to fail. Your objective should be clear – understand cash flow and valuation. Anything more than that is a diversion.


When you read through an income statement and balance sheet, you need to have the mindset of a financial detective. You need to not only understand the numbers but what the numbers say about the future. That means you are going to be focused on clues; clues to what could happen in the future, about the industry, and risk.


There are items that you 100% have to have answers to before you put your shareholder’s hard earned capital at risk. Luckily, given our experience and research, put together a starting checklist of questions that you need to answer either from the financial statements or a borrower interview.


The Checklist (in order of importance)


Capital: How much capital has been invested and how has it been used? The most important part of any financial statement is to determine or validate if the borrower has been a good steward of capital in the past. Understanding the return that has been produced and how it relates to the rest of the industry should be your first stop.


Revenue: Where does it come from and what is the quality? Bankers need to have a clear picture of the different lines of businesses, the cost to produce each dollar of revenue and the sensitivity of that revenue to interest rate or economic changes. One key question is in what areas where will future growth be generated? Are there new areas to invest in, new product lines or will growth come from expanding market share? How much of the past revenue growth have come from acquisition and how much from organic growth? Here, the more variable the revenue stream, the more time that should be spent on revenue composition and generation. 


Expenses: How can the company become more efficient? What are the contractual obligations of the company? What percent is variable vs. fixed and how fast could the company adjust its expenses in a slow down? The end result here is to have a total feel for not only operating margins and trends but increasing efficiencies is one of the major areas for future cash flow growth.


Cash Flow Changes: Bankers must question and understand any material historical period changes in revenue, profit, capital expenditures, debt, working capital, liquidity, and depreciation/amortization.


Operating Risk – What are the inherent risks in the industry? Bankers should be able to identify and understand the top three. In similar fashion, analysts should know that if a failure in operations is going to come, where is the most likely cause? Are there complicated processes involved? Is the company exposed to foreign currency changes, interest rate risk, regulatory changes or shifting consumer demand?


Tax Risk – This often overlooked section is worth spending 15 minutes on to make sure the banker is clear on any tax-deferred assets, credits, the top marginal tax rate for the company as well as the effective tax rates for state, federal and any other jurisdictions in which the company operates.  


Equity and Miscellaneous: Non-operating assets should be disclosed and listed as well as any ownership in any other entity.  For equity, bankers should have a clear understanding of the capital structure, the shareholders and know exactly who has a claim on the equity. This includes any compensation structures or option packages.




Next to understanding the above financial information, the next question to ask is that if the borrower did want to perpetrate a fraud, how they would do it? Looking back over the downturn, there was a common theme that good companies got into trouble and then tried to cover it up. These cases usually revolved around phantom revenue that was not there or phantom assets. Sometimes it was a result of nothing more complicated as creating false financial statements that bankers never asked the above questions on. Other times it was as elaborate as moving cows around, so each cow was counted three times.


The theme here should be - trust but verify. Bankers should look and what part of the financials pose the greatest risk of fraud and then figure out how to validate. This means pulling tax returns from the IRS directly and using auditors to check revenue receipts. There is more technology than ever these days so leveraging point of sale terminal outputs, Internet of Things-type sensors, plane/drone/satellite imagery, and web analytics it is easier than ever to gather more trust in financials. One smart banker, we know requested access to the borrower’s Google Analytics account so they could see directly the website traffic and e-commerce activity that was taking place. 


If the borrower is wily and intent enough, even the most astute banker will not be able to catch it. However, this isn’t to say we have to make it easy for the borrower.


Filling In the Gaps


Of course, financials won’t answer all the questions, and if they do, they will most be backward looking answers. After the above is complete, now you want to make sure you have a clear view of the future. This means that if the below are not in the financial footnotes, then they should be asked, and the questions recorded.


  1. Understand all contractual commitments for the life of the loan – Leases, contracts, debt repayment schedules, employment, pensions, healthcare obligations, etc.
  2. Know all family members and related parties involved in the company – to include vendors and associated companies
  3. Understand how the company makes decisions and what the governance is like
  4. Intellectual property ownership
  5. Existing and potential litigation


Putting This Into Action


While financial statements tell a detailed story, bankers can narrow down to at least being clear on the points above. Having all the above knowledge isn’t to say that credit losses would have been prevented. Often, a banker makes a good loan at the wrong time. However, had the above information would have been asked and understood initially, bankers would have at least known where the weak spots were so that it could apply more resources and risk management practices as to be more aware of the impending doom. More important, having the above ongoing rigorous approach would have alerted the banker to problems earlier so that the bank would have possibly had more workout options.


If your credit analysts can’t answer every one of the above questions, they either need to dig more for the answers or at least make an assumption. After reviewing credits from the downturn, a common explanation was often heard that the above information was not available and so it was ignored.  If the information is critical, it cannot be ignored. Every banker still has deep scars from the downturn, and as we head into the end of the growth cycle, bankers need to not only have long memories but need to take steps now to prevent poor underwriting from occurring.


Financials are complicated and are made even more confusing by borrowers and their professionals that don’t have the experience that most bankers would want. Make sure your credit team understands what is important, and you will not only be more accurate underwriters but be more productive underwriters as well.