When I was a junior banker, I couldn't understand why we were so focused on past financial performance. The past is past and what matters is the future, right? Only after having participated in the approval of millions of dollars in loans to hundreds of small businesses, I began to realize that while past financial successes are not always a guarantee of future achievements, a track record of profitability has proven to be a reliable indicator for risk-averse lenders. Thus, when you approach a lending institution with a loan request, one of the first questions a loan officer is likely to ask you is the number of years your company has been in business, and request to see the last two to three years of its financial statements.1
The sole purpose of this article is to give you the skills and confidence to discuss your company's financial results with prospective loan officers to help reassure them that you have your company under control. You are not expected to be a financial guru, but familiarity with some basic concepts such as income statements, balance sheets, and cash flow statements is recommended.
Income StatementsThe income statement is the cornerstone financial statement for evaluating your business's ability to make loan payments. Take a look at the last two to three years of your company's income statements. (If yours is not handy, you can look at this fictional income statement of a book-binding, repairing, and printing company Berkshire Book Services2, to which I refer throughout the article). Income statements contain two basic categories: revenue and expenses. When analyzing your company's income statement, lenders typically focus on the following questions and issues related to these two items:
- What are your company's main revenue generating products and services?
This question addresses your company's revenue composition, as a typical business has more than one product or service. It also evaluates what revenue streams are most important to your business. Berkshire Book Services procures 70% of sales from repairing services to public libraries and libraries of large corporate clients. The remaining sales come from various printing jobs, including backorders of expensive, out-of-print book titles.
- What are the driving forces behind recent revenue trends?
Trends may be declining, improving, flat (a.k.a. stable), or erratic. They can be analyzed by comparing two or more years of your company's income statements. In the Berkshire example, sales have been somewhat flat because intense competition made it difficult to attract new clients. On the positive side, the company was able to retain all of its existing customers and maintain a steady revenue trend.
- What are your company's main expenses?
Lenders typically focus only on the most significant expenses. Depending on the nature of your business, these expenses may include salaries, inventory purchases, production costs, rent, etc. Berkshire's key expenses are productions costs (paper, binding and printing materials), employees' salaries, and rent.
- What are the driving forces behind the recent expense trends?
While some business expenses may periodically decline, they typically increase over time due to inflation and other factors. Berkshire's management indicated that while the cost of paper is at an all-time low, other costs are on the rise. For instance, to provide high quality of service superior to its competition, Berkshire has to retain experienced employees, which is reflected in the steady growth of salaries.
- What factors are most important in ensuring your company remains profitable?
While the statement that sales need to grow and expenses should be kept under control applies to any small business, each company's dynamics are a bit more complex. Berkshire must grow its revenue to realize economies of scale and compete successfully with the industry's powerhouses, where "volume, volume, and volume" is the key slogan. A factor that differentiates the company from its behemoth competitors is quality of its service and attention to the need of customers that are too small for larger businesses to handle, but this alone will not guarantee profitability.
Your main goal is to provide prospective loan officers with a powerful introduction to your company's financial performance. What will make your pitch powerful is brevity, a focus on what's really important and relevant, and thorough knowledge of what is behind the most significant items on your company's income statement. During the discussion your must demonstrate to the loan officer that you are not only good at running your company, but you can also explain how your efforts translate into numbers on the income statement.
In next month's column we'll focus on the significant and typically adverse changes in your company's financial performance and how you can make lenders more comfortable with them.
1 This is not to say that lenders do not lend using projected financial statements. However, in practice a small number of loans are rarely approved on your business’ expected results. Loans to start-up and companies with recent financial losses are outside the scope of this article.
2 The name of the actual company was changed to protect its identity.