Understanding what banks look for By William Buck on 01/09/12 - Mins to read: 3 minutes 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, showing a profit is a positive sign, but when assessing the strength of a business’ balance sheet, a bank will review a number of other indicators. Financial statements will typically contain at a minimum; a balance sheet, profit and loss statement and cash flow. Each report is important and will provide a financial institution with critical information about your business. This three-part series looks at each of these reports from a typical bank’s perspective. Part 1 – The Balance Sheet The balance sheet comprises three components: assets, liabilities and equity. Assets 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 or 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 are given minimal or no value and 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. Liabilities 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 the business is fully or partially self- funded. Equity 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. Summary 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 entered into. In part two of ‘Understanding What Banks Look’ for we’ll look at the key elements of the profit and loss statement.