A lender reads financial statements to answer a short list of questions. Can the borrower pay its bills over the next twelve months, can it service the debt from operating cash flow, how much cushion does it have and can the numbers be trusted? A CPA firm that prepares the package should structure it around those questions. This article covers the analysis a lender typically runs and the preparation steps that save the client time and cost. The ratios have glossary definitions linked below, and the covenant side is in bank covenants and compliance certificates.
The questions behind the ratios
Liquidity: can the borrower meet short-term obligations?
- Current ratio. Current assets divided by current liabilities. See current ratio.
- Quick ratio. Liquid current assets (cash, marketable securities and receivables, or current assets less inventory and often prepaids), divided by current liabilities. Definitions vary, so use the lender's. See quick ratio.
- Working capital. Current assets less current liabilities. See working capital.
Debt load: how much of the business is funded by debt?
- Debt to equity. Total liabilities divided by equity. See debt to equity ratio.
- Debt relative to earnings. Funded debt divided by a defined measure of earnings before interest, taxes, depreciation and amortization.
Coverage: can operating results service the debt?
- Interest coverage. Earnings relative to interest expense. See interest coverage ratio.
- Debt service coverage. Cash flow available for debt service relative to scheduled principal and interest.
Efficiency: how well does the business turn assets into cash?
- Days sales outstanding. See days sales outstanding.
- Inventory turnover. See inventory turnover.
- Cash conversion cycle. See cash conversion cycle.
Profitability: is the margin stable?
- Gross profit margin. See gross profit margin.
- Operating margin and net margin, with trends over several periods.
Each lender and each loan agreement draws its own lines. Obtain the thresholds from the lender or from the agreement.
Trend and common-size analysis
A ratio on one date says little. Lenders compare periods and compare line items as a percentage of revenue or of total assets. Prepare horizontal and vertical analysis for at least three periods, with comments on movements. See horizontal and vertical analysis and flux variance analysis.
Quality of the numbers
Lenders discount statements they cannot rely on. The level of assurance matters: an audit, a review, a compilation and internally prepared statements carry different weight, and many lenders specify the level in the loan agreement. See AUP vs review vs audit: choosing the engagement a lender asks for. Beyond the report, lenders look for:
- Consistent accounting policies from period to period.
- Reconciled cash and debt balances.
- Reasonable allowances for doubtful accounts.
- Related-party balances and owner transactions clearly shown.
- Revenue recognition that follows the contracts.
- Earnings adjustments supported. See adjusted EBITDA add-backs and support.
Reading the cash flow statement like a lender
Lenders often start with the statement of cash flows. Operating cash flow shows whether the core business produces cash after working capital changes. A borrower with rising profit and falling operating cash flow is usually funding growth in receivables or inventory, which is a liquidity question even when the income statement looks strong. Investing activity shows the capital spending the business needs to sustain itself, and financing activity shows how it has been funded. Prepare a short note that explains the three totals and any unusual items, such as distributions to owners, proceeds from related parties or large one-time payments.
Supporting schedules
Beyond the three statements, prepare:
- Aged receivables and payables. With concentration by customer.
- Debt schedule. Lender, balance, rate, maturity, collateral and covenants.
- Fixed asset summary.
- Backlog or contract schedule where relevant.
- Interim statements and year-to-date comparisons.
- Cash flow statement. See statement of cash flows, indirect method.
- Projections. For a new loan, lenders typically ask for projections. See budgeting and forecasting for small business clients. The SBA's guidance on financial plans asks for forecasted income statements, balance sheets, cash flow statements and capital expenditure budgets, with the first year in more detail.
SBA loans
For an SBA 7(a) loan, the SBA states that the borrower applies through a local lender and that the lender decides which documents are required based on loan size and processing method. The package should therefore be shaped to the lender's checklist. The SBA also has a Lender Match tool to find participating lenders.
Preparing the package
- Ask for the lender's checklist. Required statements, periods, schedules and format.
- Close the periods. Use final, reconciled statements. See month-end close process checklist.
- Build the ratio page. Show each ratio, the formula, the periods and a short comment.
- Explain the exceptions. Unusual items, one-time gains and losses, and any covenant pressure.
- Tie everything. Statement totals tie to the trial balance, schedules to the statements. See tick and tie.
- Review as the lender would. Read the package asking what a skeptical credit analyst would ask.
- Control distribution. Send under the engagement terms and keep a record of what went to whom.
The firm role
Preparing analysis for management is advisory work. If the firm's name appears on prospective financial information or on a report the bank relies on, a different standard applies, so settle the engagement type first. See CS Section 100.
FAQ
What ratios matter most?
The ones in the loan agreement, then liquidity, coverage and debt load.
Do lenders want audited statements?
It depends on the lender and the loan. The agreement or the lender's checklist says.
Should the firm give benchmarks?
Use benchmarks the lender or the loan agreement provides. Do not use unsourced industry averages.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- SBA, 7(a) loans: https://www.sba.gov/funding-programs/loans/7a-loans
- SBA, Write your business plan (financial plan): https://www.sba.gov/business-guide/plan-your-business/write-your-business-plan
- SBA, Manage your finances: https://www.sba.gov/business-guide/manage-your-business/manage-your-finances
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error