Author: Paul Muldoon
Beware of bloated assets, understated liabilities, and unrecorded items.
Many liabilities may be out of sight, but never out of a lender’s mind. For instance, a client’s balance sheet doesn’t list pending claims, contingent costs or underfunded accounts. A proactive lender will search for undisclosed risks in order to get a complete view of their borrowers’ financial health.
Beware of Bloated Assets
The search for risks and undisclosed liabilities begins with assets. For each asset, ask yourself what could cause the account to diminish. For instance:
- Inventory may include damaged goods.
- Accounts receivable may include bad debts.
- Some fixed assets may be broken or in desperate need of repairs and maintenance.
As you can imagine, such items compromise a client’s credit standing and affect its financial ratios just as much as unreported liabilities do.
Some problems may be uncovered simply by touring the business’s facilities or reviewing asset registers for slow-moving items. And benchmarking can help.
For instance, if a borrower’s receivables are growing faster than sales, it may be a sign of aging, uncollectible accounts. Or, if a client’s repairs and maintenance expense seems low when compared to historic levels or industry norms, it might signal neglected upkeep on assets, which can be a huge gamble over the long run.
Look for Understated Liabilities
Next take a look at the borrower’s liabilities on the balance sheet and ask if the amount reported for each item is complete and accurate. A business may try to understate its liabilities in order to appear stronger or to comply with its loan covenants.
For instance, borrowers may forget to accrue liabilities for vacation time or salaries. Some might even underreport payables by holding checks for weeks (or even months). This tactic preserves the checking account while giving a lender the impression that supplier invoices are actually being paid.
Other clients might hide bills in a drawer at year end in order to avoid recording the payable and the expense. This “scam” mismatches expenses and revenues, artificially enhances profits, and understates liabilities. Moreover, delayed payments can hurt the business’s credit score and even cause suppliers to restrict their credit terms.
Uncover unrecorded items
Make sure you investigate what isn’t showing up on the balance sheet. Examples include pending lawsuits, warranties, an IRS investigation or an underfunded pension. When available, look at the balance sheet footnotes. They may shed additional light on the extent and nature of these contingent liabilities.
These risks appear on the balance sheet only when they’re “more than likely” to be incurred and “reasonably estimable.” They are subjective standards. Some borrowers may claim that liabilities are too unpredictable or remote to warrant disclosure.
Lenders should also consider the goodwill (or badwill) that’s attributable to the company’s owners and top managers. For instance, certain “key” people may be so critical to the company’s success that their unexpected departures might expose the entity to financial hardship. On the other hand, people who are exceptionally tax averse, risk-seeking or unethical can put the company at risk for IRS inquiry, lawsuits, and insurance and warranty claims.
Work with a pro
If a business’s financial statements are audited, the auditor will automatically test for these hidden risks and liabilities. They also watch for any exaggerated asset balances. Keep in mind that compiled or reviewed statements aren’t subject to the same level of scrutiny.
For added assurance from any questionable borrowers, ask for an agreed-upon-procedures engagement that can target high-risk areas and anomalies. If a ratio analysis reveals unusual trends based on the client’s track record or industry benchmarks, you may want to meet with the borrower and its accountant in order to hunt for any hidden liabilities and risks.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can help you reduce the risk of lending or assist your clients with our business advisory, audit, fraud detection and prevention, and tax services.
For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.
Introduce Benchmarking to Add Value and Protect Clients from Financial Distress
Author: Paul Muldoon, CPA, CIA, CFE, Senior Manager
As a lender, you can add value and protect yourself from financial distress by introducing your borrowers to the benchmarking process.
A case study
When Jane Anderson switched banks to consolidate her company’s debt and lower its interest rates, she received an unexpected, but delightful bonus — financial insight — from an unexpected source: her new banker.
As part of its normal due diligence protocol, her new bank benchmarks every borrower’s financial statements against Risk Management Association industry norms. And, if a borrower doesn’t measure up, the owner receives a friendly follow-up call.
When the banker phoned Jane, he pointed out that her company’s days-in-receivables was some 15 days longer than the industry average and its days-in-inventory was almost double the norm.
Jane became defensive, saying, “You need to spend some time in the real world! Our collections have been around 65 days for decades. Our customers simply won’t pay faster!”
The banker responded kindly by pointing out that her portfolio included other borrowers in the same industry, and of roughly the same size, that matched the benchmarks. Although Jane’s performance didn’t violate any loan covenants, he recommended that she consult a CPA to get her company’s asset management back on track.
Thanks to the banker’s insight, Jane’s average collection period is now down to 54 days. She’s also taking training courses on inventory management software to help her assess safety stock (which is simply a level of extra stock maintained to mitigate risk of stockouts) and reorder points. And she’s been able to free up cash to spend on some new equipment as well as pay shareholders an unexpected dividend.
Look at the entire picture
Of course, changes in a borrower’s performance over time are only part of the story. Just because a company has survived for 30 years with a 65 days-in-receivable ratio doesn’t always mean it’s healthy. After all, a collection period of 65 days is totally unacceptable if competitors collect in 50 days.
Lenders and owners must gauge how others in the industry are doing in terms of growth, asset management, profitability and debt coverage. Major expenses that are worthy of comparison are rent and management compensation, especially if paid to related parties.
No universal benchmarks will apply to all types of businesses. So it is critical to seek data that’s sorted by industry, size and geographic location. Also, encourage borrowers to share any data they get from trade journals, local roundtable meetings or conventions.
As you’ve likely gathered, benchmarking data has certain limits, and comparisons may be imperfect. But it will always provide some insight, no matter how small a niche your borrower’s operations may be.
Ratios are also a moving target
Ratios also tend to change over time. If more competitors enter the marketplace, for example, collections may slow and margins will narrow. Why? Because the more suppliers there are in an industry, the less control those suppliers will have over their customers.
There are other factors that can affect ratios: regulations, technology and economic conditions. So be sure to employ current benchmarking data to avoid setting unreasonable goals. You must also realize that benchmarking is a continuous process, not a one-time event.
We’re here for you
If during a preliminary benchmarking you find any weaknesses, make sure you refer the business to a CPA for more detailed insight. He or she can help tutor the borrower, as well as implement change and bring grades up to par.
For more information on benchmarking or any other asset based lending issue, give us a call at 716.847.2651, or you may contact us here.
Why mounting reserves may not be good for lenders
Author: Paul Muldoon, CPA, CIA, CFE Senior Manager
As the recession plods along, it’s likely that borrowers might take a rather conservative approach to liquidity. In fact, according to the 2012 AICPA Business and Industry Economic Outlook Survey, more than a third of CFOs are stashing away more operating cash flow in their bank accounts than ever before. And some don’t even have plans to deploy their cash reserves.
While rainy day funds might be reassuring to lenders, excessive kitties could be a very inefficient use of capital that borrowers may regret down the road. What’s needed? A scientific approach to estimating reasonable cash reserves. With such an approach, borrowers can reinvest surplus cash in higher yield alternatives that may improve their long-term financial positions.
While an extra cushion can help a business weather downturns or fund unexpected repairs and maintenance, cash has a heavy carrying cost: the difference between the return that companies earn on their cash and the price they pay to obtain cash.
Checking accounts often earn no interest, for instance, and savings accounts may generate returns below 2%. Most cash “hoarders” will simultaneously carry debt on their balance sheets, such as mortgages, equipment loans and credit lines. They often pay higher interest rates on loans than what they’re earning from their bank accounts. This spread indicates the carrying cost of cash. How much is too much?
Consider the question: What’s the optimal amount of cash that should be kept in reserve? Unfortunately, there’s no crystal ball that can indicate the current ratio or percentage of assets you can prescribe for your borrowers. A bank’s liquidity covenants may provide an educated guess about what’s reasonable.
But your bank can analyze how a customer’s liquidity metrics change over time or how liquidity ratios compare to certain industry benchmarks. If you encounter huge increases in liquidity — or even ratios that are well above industry norms — that may indicate an inefficient deployment of capital.
When a customer’s cash seems to be on the high side, suggest that the CFO or a CPA project financial statements for the next 12 to 18 months. A monthly projected balance sheet, for example, might estimate seasonal ebbs and flows in the borrower’s cash cycle. A projection of a worst-case scenario can be used to establish the borrower’s optimal cash balance. Keep in mind that projections must take into account the business’s future capital expenditures, cash flows, working capital requirements and debt maturities.
Formal financial forecasts can provide a way to build up cash reserves, which is much better than relying on the borrower’s “gut” instinct. Moreover, borrowers should compare their actual performance to projections and make needed adjustments.
Reinvesting cash surplus
It’s critical that management look for ways to reinvest its cash surplus in order to earn a higher return. A borrower might choose to acquire a competitor — or its assets. A borrower with excess cash may be in prime position to profit from a competitor’s failure. Formal due diligence is key for customers expanding via acquisition, to avoid impulsive, unsustainable projects.
The business can also invest in marketable securities. Cash accounts typically provide just a nominal return. In 2013 the FDIC will stop its unlimited insurance coverage for non-interest-bearing corporate accounts. Thus, more aggressive borrowers might choose to go with mutual funds or diversified stock and bond portfolios. A financial planner can help such borrowers choose securities.
Another key move is to repay debt. Doing so reduces the carrying cost of cash reserves. Lenders, of course, look favorably upon borrowers who try to reduce their debt-to-equity ratios.
Some businesses may also choose to use surplus cash to repurchase stock, especially when minority shareholders challenge the owner’s decisions.
Use your gut instinct
Your borrowers likely excel at their daily business operations. But many rely on gut instinct to manage their administrative functions — including finance and accounting. Borrowers who are too conservative may need some professional insight into the highest and best use of their assets.
For any questions on liquidity or any other asset based lending issue, contact us here or give us a call at 716.847.2651.