Loan officers tend to focus on historical finances, as I noted in my last column, and for good reason: They provide a track record of your business's performance and offer lenders a glimpse as to what it might look like in the future. This is why it's important to be prepared to discuss your company's financial track record, especially within the last two or three years, and any significant changes that have occurred during that period when seeking a bank loan.

"Significant" means a sizeable dollar amount or a significant percentage change of individual items in your company's financial statements. For instance, doubling of your company's inventory from $100,000 to $200,000 or an increase in rent from 10% to 20% of total revenue would likely spark an inquiry.

You particularly should focus on what lending officers are likely to perceive as negative changes. A small business owner's ability to discuss the negative trends and assure lenders that the situation is under control is the key to maintaining an existing loan relationship and securing new loans.

It's impossible to cover all adverse events that can impact your company's financial health. However, the most typical negative changes in your company's financial performance that you should be prepared to discuss are:

  • Significant decline in revenue
  • Sizeable increase in expenses, such as salaries, materials, shipping, rent, and others
  • Operating losses prior to payment of interest expenses and taxes
  • Negative cash flow, as measured by EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) or other methods
  • Slow inventory turnover, slow accounts receivable collections, or slow payment of accounts payable
  • Owner's distributions in excess of earnings
  • Limited or even negative owners' equity in the company
  • Very limited investments in equipment when your company is growing by leaps and bounds or significant investments in equipment when your company is not growing

To better prepare yourself for the tough questions, I've outlined a number of step you can take before sitting down with a lender.

Step 1: Identify significant, particularly negative, changes in your financial statements.
Closely examining your company's financial statements before meeting with lending officers. As simple as it sounds, I have worked with many small business owners who were not aware of various changes in their companies' financial reports.

This income statement from a restaurant provides a good example. On it, you'll see that revenue declined by about $70,000 over a two-year period, while operating expenses, particularly salaries, increased by about $12,000. On the positive side, the restaurant improved its gross profit margin from 73% to 75%. Having knowledge of similar changes on your income statement can help you prepare answers for any question the lender might have.

Step 2: Explain what is causing the changes.
Be able to provide reasonable, complete explanations of the trends and changes you identified in Step 1 as well as their causes. In the restaurant example, revenue in 2001 declined due to the economic recession in the region and the impact of the terror attacks of September 11. Salary increased primarily because the owner hired a new executive chef and a new dessert chef, both of whom were very reputable and required higher salary.

Step 3: React to ensure that the negative impact on your company's financial health is reduced or eliminated all together.
A crucial element of addressing deteriorating financial performance is reacting to cure the situation. If a negative event is relatively recent, and there was absolutely no time to react, you at least should have a plan of action. This will tell the lender that you are on course to make improvements. Considering that lenders receive your companies' financial statements from several weeks to several months after the end of a financial period, having a plan of action is expected.

In the restaurant example, the owner hired the two star chefs to improve the quality of food and to attract new customers. In addition, the owner joined a co-op to secure lower prices on liquor and fresh produce.

Step 4: Demonstrate to the lending officer the steps you have taken to improve the situation and the results your actions have produced Being able to discuss your efforts is as important as following through on your plan of action. Otherwise how are lenders supposed to know that you are making progress? In this step your goal is to provide proof, whether quantitative or qualitative, that you have taken action to improve your business's financial performance. In addition, you should share the results your actions have produced. The owner in our example showed that joining the co-op helped improve gross profit margins.

If you are not able to answer some questions related to your company's financial performance, jot them down and promise to follow up promptly. It is always better to give the correct information later than the wrong answer on the spot. If you forget to follow up in a timely manner or provide incorrect information and a lending officer catches that, your credibility could go out of the window.

Also, remember to be honest and forthcoming about your company's deteriorating performance. Shying away from a difficult conversation with your lender may be a preferred choice, but my experience has taught me that being honest with your lender is a better way of recruiting his or her cooperation.