Seeking finance can be a daunting task, even for the most confident business owner. But, with careful planning and a clear view of what the banks are looking for, the burden of obtaining finance can be greatly reduced.
Many business owners mistakenly believe that money in the bank account and good profits represent strong financial statements. Of course, profit is a positive sign, but when assessing the strength of a business’ balance sheet, a bank will review several other indicators.
Financial statements will typically contain at a minimum: a balance sheet, profit and loss statement and cash flow projections. Each report is important and will provide a financial institution with critical information about your business. When you combine these, it’s called a three-way forecast.
Here we look at each of these reports from a typical bank’s perspective.
The balance sheet
The balance sheet comprises 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. Similarly, fittings, equipment and lease-held improvements are not significant assets from a lending perspective – mainly because, if a bank forecloses on a loan and a business is not a going concern, they will have a poor resale value.
On the other hand, tangible, illiquid assets such as property and 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 help secure bank finance but, while the dollar value is important, the bank will look closely at the quality of the assets. Slow-moving stock and low stock turnover will undermine a balance sheet, as they often represent a poor value asset.
When reviewing accounts receivable, the bank will attribute greater value to 30 and 60-day debtors. Debtors in excess of 90 days may even have an unfavourable impact. Similarly, 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 has the effect of cancelling the asset out.
Large creditors (accounts payable), particularly those greater than 30 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 will be viewed positively by the bank. In fact, in a family or discretionary trust, the beneficiary loans are treated more or less as equity. These loans represent capital injected or profits left behind in the business and indicate that it’s 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.
Banks will also look closely at contingent liabilities, such as guarantees provided by the business or its directors and potential liability concerns such as pending court action.
When it comes to the balance sheet, strong cash flow and sustained profits are good indicators, but a bank will closely scrutinise the report. It will assess the business’ strength and the asset coverage of the funds lent to ensure that the business can afford any financing arrangements made.
Profit and loss statement
Financial institutions will typically want a minimum of the last two to three years’ profit and loss statements. While strong profits are a good indicator, the bank will often delve deeper into what is behind the profit. Firstly, it 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 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.
They will also investigate revenue to understand if the business has been growing or contracting. 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 pay. It may be that profit is high, but the directors are drawing minimal wages.
Conversely, profit may be on the low side but closer inspection reveals that the owners are drawing large wages, salary sacrificing into superannuation and are receiving salary packaged items such as cars, etc. In this respect the business may be very profitable but the owners are drawing out the profits.
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 cash flow to repay a loan.
To understand 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 cash flows. The cash flow will demonstrate the direction the business is going, including growth expectations and 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. The overdraft enables a business to deal with the peaks and troughs of cash flow.
For instance, many retail businesses will have fluctuating cash flow requirements around Christmas. Prior to Christmas, the business may need significant cash reserves to build up stock levels then throughout December the stock will be converted to cash sales, taking pressure off overdraft facilities.
Importantly, when preparing a cash flow, 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 cash flow should incorporate the additional interest payments required on this facility.
And the forecast must be realistic. Businesses often prepare extremely optimistic profit projections to gain favour with the bank, but you don’t want to give the impression you don’t need money from the bank. Be careful not to 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 it wants to know will make a significant difference.
If you need assistance to collate the right financial reports to apply for a loan, or would like strategic planning or financial advice, please contact your local William Buck Business Advisory specialist.