From the February 2006 edition of the Turnaround Management Association’s Journal of Corporate Renewal
Lenders probably wish they had a crystal ball to determine which of their customers are currently experiencing problems that will lead to increased lender risk in the future. In reality, they have something that works even better, if they know where to look.
From February through April each year, lenders you typically receive the majority of your customers’ year-end financial statements. This is the perfect time to take a hard look at your borrowers to determine which ones are exhibiting warning signs of future problems. Spotting early warning signs provides an opportunity to push for refinancing, bring in outside consultants to improve performance, or renegotiate the relationship to protect the lender’s assets better – all before a financial crisis hits.
The delivery of the annual financial statements provides an opportunity for a lender to have a casual conversation with the business owner and / or CFO. This conversation should be well scripted from the lender’s point of view. Although a lender probably will not pull out a list of questions and go through them at this time, a short list of questions should be developed that are always asked during any meeting in which annual financial results are delivered.
A few well-placed questions will tell lenders which of their borrowers are exhibiting warning signals of future trouble.
During your interviews with borrowers, a lender should consider asking the following questions:
- How many stock keeping units (SKUs) were in the product line last year versus this year? The lender should look for sudden increases or decreases in SKUs and should ask if an inventory aging by SKU exists.
- What is the capital expenditure justification process? The lender should ask for an explanation for the larger capital expenditures that occurred during the year. A lender should try to determine who makes decisions and if any type of financial analysis justifying the expenditure takes place prior to the asset purchase.
- How is the sales forecast developed? A lender should determine whether the forecast is prepared from the bottom up or from the top down and should try to determine how accurate past forecasts have been.
- How does the production planning process work, from determining what to manufacture, how to staff, and how to purchase, to how and when to take delivery of inputs? Who is responsible? How does senior management explain the process? Is the customer losing orders by missing ship dates?
- Who develops the first run of the budget? A lender should try to assess the involvement of all levels of the borrower’s organization in its budgeting process. A lender should determine whether the borrower uses the zero-based budget approach or begins with what was spent last year.
- How is the cost of goods sold developed? This is the lender’s opportunity to ask about such issues as standard costing, variations from standard and inventory adjustments.
- What is the pricing strategy? A lender should look for clues about competition, planned price increases, and any issues with key customers.
- Is an employee performance appraisal system in place? Are reviews of performance completed at least annually? Are decisions made based on the performance appraisals?
- Does the borrower have daily and/or weekly “key indicator” reports? If so, the lender should ask for copies of them.
- What is the book and bank cash balance? A lender should determine how involved in cash management an owner and CFO are. Who tracks the daily cash balance? Are weekly cash budgets developed?
- How does the lender rate the CFO? Does the owner rely on the CFO for information? How does the owner rate the CFO’s performance?
Answers lenders do not want to hear are not necessarily indicative of a loan write-off or serious problem. After all, these questions were developed to provide a lender with early warning and therefore help avoid loan write-offs or other serious problems.
Digging Deeper
The annual financial statement interview is key to the loan management process. Recently a lender reviewed a financial statement which indicated that a company’s sales had dropped but profitability had increased, gross margin had improved, and fixed assets had increased. Does that sound like good news? Should the lender file away the financial statement and wait for another good year?
During the annual financial statement interview - which had to be rescheduled three times because of conflicts and excuses on the part of the borrower - the lender learned that the fixed assets had been revalued based on a seven-year amortization rather than a five-year amortization. This resulted in an increase in fixed assets of $2 million. Gross margin improved because depreciation was not an expense but rather an income item. Therefore, extending the depreciable life of the assets resulted in all the good news the lender received.
Based on the information gleaned in the annual financial statement interview, this lender increased field exam frequency and began to build reserves. Without the interview, the lender would have filed the financial statement in the drawer and been surprised at the next field exam.
In another case, a lender received an annual financial statement related to a privately held company. The financial statement arrived several months late but indicated stable performance. During the annual financial statement interview the lender learned that the owner of the company had been out of town for the first two months of the year, which should not be a problem for a company performing at a stable level. However, because all decisions funneled through the owner, the backlog had reduced to 25 percent of its normal level, and the accounts receivable aging was very close to turning over to 75 percent over 90 days past due.
Based on the information in the annual financial statement interview, this lender increased reporting to track backlog, retainers, and holdbacks better. Also, the lender recommended that a consulting firm be brought in to secure a second tier of management. As a result, the owner of the company was able to sell the business within two years, and the lender financed the new owner.
These lenders were confronted with financial statements that looked good on the surface and could have been filed away without a second thought. However, the interview associated with delivery of the annual financial statement allowed the lenders to learn more about the companies than was reflected in the financial statements.
Each situation is unique, but there is a short list of alternatives to consider if a borrower shows early warning signs of problems:
- Increase financial statement reporting frequency. Enforce any deadlines for receipt of financial information.
- Order a field exam or increase existing field exam frequency. Based on the answers to the questions, a field exam can be directed to focus its attention on areas of concern. For example, if cost of goods sold is a concern, inventory tests should be expanded. If cash balance is a concern, cash receipts and disbursement tests should be expanded.
- Add additional reserves to the borrowing base. Based on the answers to the questions, a lender should look for weaknesses in the liquidation value of its collateral. For example, if there are substantial increases in SKUs and the inventory aging by SKU is not available, the reserve for slow-moving inventory should be increased until the lender’s concerns are alleviated.
- Ask for a third-party assessment of the borrower. Most lenders are comfortable with their in-house credit team and their field exam group. But an overall operations and management evaluation rests on the shoulders of an already stretched account executive. As a result, lenders do not typically have the time to delve into the details of the business operation in time to protect themselves.
‘Tis the Season
The time of year for receipt of annual financial statements is fast approaching, so lenders should develop their interview strategies now to use on all borrowers as they deliver those statements. By expanding its line of questioning and formalizing its approach to interviewing borrowers, a lender can find the crystal ball that indicates which borrowers are experiencing problems.