Many currently problematic loans once looked good on paper — but now, aren’t worth the paper they’re printed on! To ensure your bank doesn’t succumb to the lure of loans that seem to be — and are — too good to be true, it’s important to have a policy of conducting proactive due diligence practices from the start. That way, you’ll help your loan portfolios remain stable and profitable over time.
Steps to consider
Start the due diligence process as an auditor would. That is, before you open a borrower’s financial statements, consider documenting the risks in the industry, applicable economic conditions, and the borrower’s business operations and collateral sources.
This risk assessment identifies what’s most relevant, where your greatest exposure lies, what trends you expect in this year’s financials and which bank products the customer might need. Risk assessments save time because you’re targeting due diligence on high-risk areas.
Financial risk
Now tackle the financial statements, keeping in mind your risk assessment. First evaluate the reliability of the financial information. For statements prepared by an in-house bookkeeper or accountant, consider that individual’s skill level and whether the statements conform to Generally Accepted Accounting Principles. If statements are CPA-prepared, consider the level of assurance: compilation, review or audit.
Comprehensive statements include a balance sheet, income statement, statement of cash flows and footnote disclosures. Make sure the balance sheet “balances” — that is, assets equal liabilities plus equity. You’d be surprised how often internally prepared financial statements are out of balance.
Statements that compare two (or more) years of financial performance are ideal. If they’re not comparative, look at last year’s statements. Then, note any major swings in assets, liabilities or capital. Better yet, enter the data into a spreadsheet and highlight changes greater than 10% and $10,000 (a common materiality rule of thumb accountants use for private companies). You should also highlight changes that failed to meet the trends you identified in your risk assessment. For example, you expected something to change more than 10% but it didn’t.
Now ask yourself whether these changes make sense based on your preliminary risk assessment. Brainstorm possible explanations before asking the borrower. This allows you to apply professional skepticism when you hear borrowers’ explanations.
Ratios for analysis
Use your risk assessment to create a scorecard for each borrower. It often helps to discuss your risk assessment with co-workers and to specialize in an industry niche.
One ratio that belongs on every scorecard is profit margin (net income / sales). Every lender wants to know whether borrowers are making money. But a profitability analysis shouldn’t stop at the top and bottom of the income statement. It’s useful to look at individual line items, such as returns, rent, payroll, owners’ compensation, travel and entertainment, interest, and depreciation expense. This data can provide reams of information on your client’s financial health.
Other useful metrics include current ratio (current assets / current liabilities), which measures short-term liquidity or whether a company’s current assets (including cash, receivables and inventory) are sufficient to cover its current obligations (accrued expenses, payables and current debt maturities). High liquidity provides breathing room in volatile markets.
In addition, total asset turnover (sales / total average assets) is an efficiency metric that tells how many dollars in sales a borrower generates from each dollar invested in assets. Again, more in-depth analysis — for example, receivables aging or inventory turnover — is necessary to better understand potential weaknesses and risks.
Finally, calculating the interest coverage ratio (earnings before interest and taxes / interest expense) provides a snapshot of a company’s ability to pay interest charges. The higher a borrower’s interest coverage ratio is, the better positioned it is to weather financial storms.
When applying these metrics, compare a company to itself over time and benchmark it against competitors, if possible. If customers’ explanations don’t make sense, consider recommending that they hire a CPA to perform an agreed-upon-procedures engagement, targeting specific high-risk areas.
Worth the extra effort
Digging deeper into the financial statements to determine what’s really going on within the operations of existing and potential borrowers may seem unnecessary in the face of what they’re already reporting. But to ensure those reports are based on sound facts and analysis, take a closer look. The health of your bank’s loans depends upon it.
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