An easy guide to getting your head around these documents
Having a basic understanding of company financial statements is a core part of the commercial lending space, we braved the figures and accounting jargon to deliver an easy guide to getting your head around these documents
Even though the reports and numbers which are churned out by companies - and verified by their accountants - instil a strange fear and aloofness in many a broker, industry professionals assure anyone who is either a part of, or would like to enter, the commercial space that there is nothing to fear from financial statements - it's as simple as knowing the client, the business and doing a bit of simple maths.
Understanding the client
The business clients which most commercial brokers work with generally reside within the small to medium spectrum - usually within the half to three million dollar space. In view of this, the financial statements for these companies are not as complex and multi-faceted as for larger, ASX-listed corporations.
However, despite the relatively small scale of these operations, it is important to remember that brokers, no matter how knowledgeable, cannot be expected to be accountants and therefore should work closely with a client's accountant to understand the financial statement.
The main parts of a financial statement that are of interest to brokers are the balance sheet, which lists all of the assets and liabilities of the company, and the profit and loss (P&L)/income statement, which reports the revenues, expenses and profits of the business. When it comes to assessing the serviceability of a commercial client, this relies predominantly on two factors - the business' historical financial performance and the projected (or future) performance. Each can be derived mostly from those statements.
Historical financial performance
Within this segment, the bank looks at the profitability of the company and its ability to service the loan. This means that operating profits before tax and add-backs are to be included in the assessment. Although the time period covered differs between lenders, generally two or three years of historical financial statements are required.
The balance sheet is imperative to understanding the business' history as it offers a 'snapshot' of the company's underlying financial strength. In looking at this part of the financial statement, Glenn Maynard, director at commercial lender Think Tank, emphasises that it is particularly important for brokers to understand their client business' liabilities - who they owe money to and how they've compared from one year to the next.
Profit and loss (income) statement
A key indicator of historical financial performance, however, is the profit and loss statement, which reveals how much profit a company has made.
In order to determine a client's ability to repay, a broker has to look at the operating profit as well as at what adjustments can be made to the profit.
"The worst mistake is taking the bottom line net profit or loss and not taking into account how that is derived," says Gary Davis, director of Commercial Brokers Australia. Naturally, there are all sorts of add-backs that can be used to beef up the bottom line, depending on the nature of the company.
1. Interest paid
An example of an add-back is if a company has interest paid. "If you have to allow for loan repayments, then of course you have to add-back in the interest expense," Davis explains.
For example, if a business has paid off $10,000 on a commercial or business loan that they currently hold, that interest can be added back to the operating profit. This means that the $80,000 worth of expenses (Figure 1) might include the $10,000 worth of interest paid to the bank. In this case, an adjustment can be made to the profit which takes it up to $30,000 to demonstrate a company's ability to repay.
2. Non cash flow items
Other things which can also be added back include non cash flow items such as depreciation. According to Davis, depreciation is "the forward catering replacement of an asset and it's a paid-for expense and, while not physically outlaid, is a deductible expense". Davis adds that while some lenders do not, there are many who do allow depreciation to be an 'add-back' to operating profit.
In the example (figure 1), this means that $5,000 worth of depreciation can be added on to the $80,000 worth of expenses. When this is added to the $10,000 worth of interest and $20,000 worth of profit, the sum which the client can work with to repay the loan is increased to $35,000.
Wages should also be considered within the figures. Since the majority of businesses that brokers work with are of a small to medium scale, quite often they are family businesses and directors often take wages out.
This means that the initial $80,000 of expenses might include $40,000 worth of wages. These wages which are received by directors can demonstrate loan serviceability. This means that if you add your $20,000 worth of profit to the $15,000 worth of add-backs and further add $40,000 in wages, the pool of available cash flow has increased to $75,000.
However, according to X Inc's financial consultant, Grant Rheuben, if there are multiple people receiving wages out of the company, brokers need to remember that directors are not going to be separately identifiable.
So in order to ascertain how big a portion is paid to directors, you have to obtain the director's tax return from the company's accountant.
Think Tank's Glenn Maynard cautions brokers to make sure that when they are assessing the director's personal tax returns as well as add-backs that they do not fall prey to "double dipping" - a practice in which the same income is used more than once.
It is also necessary to recognise what will happen in a company's future in terms of commercial transactions, such as projected cash flow or budget, in order to be able to determine how likely it is to move forward.
This is particularly important if the business is looking to expand into new territory or is anticipating a change of some sort as a means to illustrate to a lender where it is heading.
So while historical financial performance figures might indicate that the business had generated revenue or turnover of $100,000, it might be expected or anticipated that these will double, becoming $200,000.
When it comes to preparing an accurate projection, brokers should get either the company's accountant or a qualified financial accountant to prepare the document based on what the budget of income or revenue is likely to be as well as what the expected expenses are going to be. It is often important for lenders to know how the borrowed money is going to be used.
This is often prepared on a month-by-month basis for a period of several months into the future. Rheuben suggests that were one to be prepared in the first quarter of this year, it would probably be best to prepare it until the 31 December 2008 to give the lender an understanding of where the company is likely to be headed.
The most important point for brokers, in terms of the projected performance, is that they need to understand how the figures for this projection were determined.
"It's very, very important that, if any cash flow or budget is prepared or provided by the accountant, that the broker obtains the list of the assumptions that were used in the budget or cash flow projection," Rheuben says.
"For example, if a business is saying that the turnover is going to increase by 50%, you need to know the justification and assumption behind that."
Basic finance statement essentials
When looking at a company's financial statement, a broker needs to assess five things:
1) What does the company do?
2) How did it perform?
3) What was its profit?
4) Are there any add-backs (eg, depreciation, wages)?
5) What are the directors' salaries?
These five areas should be enough to demonstrate that a client can repay the loan.
What to look out for
As discussed, applying for a commercial facility varies depending on what type of facility is required, be it a property purchase, equipment facilities or factoring. In relation to the financial statements being received, the first things I look at (much like a personal return) are:
* Net profit - this gives an indication to whether the company is trading profitably
* Depreciation - this gives an indication of 'add-backs' or paper deductions; by adding these figures back, it can increase the company's profit
* Wages - does the director(s) take a salary in addition to any profit that may also be taken (this needs to be compared to the personal returns)
* Directors' salaries - same as above
Other points to consider:
* Related party loans - do they represent a large proportion of assets?
* Valuations on the balance sheets - is it a director's or qualified valuer's estimate?
* Asset revaluation reserve - on what basis is the reserve created?
* Goodwill - does this increase the value of assets?
* One-offs/extraordinary items - eg, equipment sales, natural disaster
Tip: "The most important bit of advice is to establish a good relationship with a commercial banker that can help with the assessment of any type of facility."
Source: Jade Consulting (Qld), Jade Financial Solutions
A word on big business:
"Complicated," is how Gary Davis, director Commercial Brokers Australia describes the financial statements of large companies.
While Davis tells AB that a relatively "straight up and down family company or a company with a family trust" is "relatively easy" to understand, once there are "multiple entities, transfers, inter-entity loans, borrowings from one entity to another and a multitude of other complications" it becomes much harder to work through a financial statement - and the bad news is that once the basics are covered it is pretty much a case-by-case scenario.
"There are multiple ways to do things. I suppose the best analogy is that you need to look at it upside down and sideways as well as just what's in front of your face," Davis explains.
His advice to any broker who would like to get more heavily involved in the commercial space is to "get as much exposure and don't be afraid to take on a commercial enquiry ... refer to people that have commercial experience and gain knowledge about different industries".
Head teachers of accounting at the Northern Sydney institute of TAFE, Cameron McDonald and Dilhara Gonsalkorale suggest that it might be beneficial for brokers who are working within the commercial sector to specialise within a particular industry.
According to these experts, if a broker has an understanding of a particular industry, they are more likely to be sensitive to particular issues, strengths and weaknesses within a business and are therefore better aligned to identify the elements which require particular attention when viewing more complex financial statements.
Associate professor of accounting at the University of Sydney Philip Lee weighs in on this point by stating that brokers should understand the business itself.
"Whether [a business] is going to get cash this week or next week is not the issue; the question is there ever going to be any cash," he says, adding that this can only be determined if the business is properly understood.
Courses that will help brokers become accounting savvy:
* Diploma of Financial Services at Kaplan Professional (http://www.kaplanprofessional.edu.au/Financial_Services/Vocational_Education/DFSFM)
* Certificate III in Financial Services
* Certificate IV in Financial Services
* Diploma of Accounting
* Advanced Diploma of Accounting at TAFE (http://www.tafestudy.info/index.html)