The movement of money is required for a community’s economic health. Lending is one significant type of flow of funds that has the potential to increase economic growth by supporting business growth. However, the lender has to be cautious all along as making the wrong lending decisions can be disastrous.
The ongoing pandemic continues to hurt businesses and loan repayments. According to Money Control, banks are bearing staggering losses to the tune of Rs 1.53 lakh crore in FY 2021 due to non-payment of loans. This figure has increased by 6% in FY 2021, compared to 2020. Therefore the focus on the soundness of a lending decision has gained more importance in the modern day.
How can you ensure that you lend safely?
This is where Financial Statements come in. They are a powerful tool that can help you assess the ability to repay or creditworthiness of potential clients so that you can make better lending decisions that are profitable to you, beneficial to the borrowing business and advantageous to the community.
What are Financial Statements?
The following are collectively referred to as Financial Statements:
- Income Statement
- Balance Sheet
- Cash Flow Statement
- Statement of Changes in Equity
- Notes to Accounts
Each line item is a summary of similar accounting entries. The five statements put together indicate the financial health of a borrower, ranging from revenue to profitability to capital. Further information can be deduced from the financial statements to gauge the ability of a business to repay or service a loan in a timely fashion.
Financial Statements give valuable information on the following crucial aspects:
Revenue is the annual sales amount of a business. Financial statements begin by showing the avenues of revenue along with the corresponding figures of the previous year, so that increase or decrease in sales can be tracked. Revenue is one of the most important indicators of overall performance because this is the basis on which a business can run. For a deeper understanding, revenue trends, captured by the Compounded Annual Growth Rate or CAGR, can also be studied.
The ultimate aim of a for-profit organisation is to make money i.e. generate profits. This is disclosed in the Income Statement by the following profit figures:
- Operating Income (Earnings before Interest, Tax, Depreciation and Amortisation or EBITDA)
- Earnings before Interest and Tax (EBIT)
- Earnings before Tax
- Profit after Tax (PAT)
Based on the numbers given in the financial statements, profitability indicators can be computed as percentages of the above on the basis of Sales for the year. These facilitate easy understanding and comparison to prior periods. Of these indicators, the Operating Margin calculated as a percentage of EBITDA/Sales and the Net Profit margin calculated as a percentage of PAT/Sales are considered to be the most significant.
The liquidity of a business refers to the amount of cash and cash equivalents that it has. The more the amount, the higher the liquidity.
It is preferable for a lender to have a borrower who is more liquid because the latter will have the funds to repay the former’s loan even if the operations are inefficient or the business is slowly turning unprofitable. The financial statements play a crucial role in determining liquidity by clearly pointing out the amount of cash and bank balances.
Furthermore, indicators of liquidity, such as the Current Ratio and Quick Ratio, can be computed by comparing these numbers with short-term obligations or current liabilities to determine how much of the immediate obligations can be met by the business on very short notice.
4. Operational Efficiency
Is the business making use of its assets well? Is it managing its inventories, debtors and creditors properly? Operational efficiency indicators answer these questions. A business may generate revenue and be profitable. However, if they operate inefficiently, it is a cause of concern for lenders as it affects the ability of the business to repay loans.
Financial Statements disclose information that can be used to compute financial ratios that indicate operational efficiency. A few examples of these are Fixed Assets Turnover Ratio, Debtors Turnover Ratio and Creditors Turnover Ratio.
5. Capital Structure
In very simple terms, capital structure is the proportion of debt and equity. Debt refers to long-term loans and equity refers to the amount brought into the business by the proprietor or raised in the market by issuing shares. There are various types of equity and debt. Knowing about the capital structure of a business is essential before taking a call on lending since a higher amount of debt directly impacts the ability of a borrower to service the loan on time.
The financial statements of a borrower, particularly the Balance Sheet and the Statement of Changes in Equity, clearly disclose the constituents of its capital structure and quantum of each constituent, to facilitate computation of key indicators like the Debt-Equity Ratio, computed as Total Debt/Total Equity.
Ultimately the lender needs to know the ability of a borrower to repay a loan. The financial term for this is coverage. Measures of coverage are calculated based on key information disclosed in the financial statements (particularly the Income Statement and Balance Sheet) and expressed as a decimal number. The higher the number, the better the creditworthiness of the borrower. There are two key indicators of coverage:
- Interest Coverage Ratio (ICR), calculated as Operating Income/Interest expense
- Debt Service Coverage Ratio (DSCR), calculated as Operating Profit/(Interest expense + Principal repayment)
Coverage ratios are extremely important and these calculations are a basic necessity for making lending decisions. Without the presence of financial statements to compute these indicators, it would be almost impossible to decide whether or not to lend to a specific borrower.
7. Bank Statements
In addition to financial statements, bank statements should not be ignored while making lending decisions. Bank statements refer to a record of all banking transactions for a specific period of time. For wholesale borrowers, the lender must request the following:
- A list of all the bank accounts used for business purposes
- Monthly or quarterly statements for each of business accounts, for at least three preceding years, or statements since the commencement of the business, whichever period is longer
Bank statements reveal the quantum, frequency and nature of transactions. A lender will be able to deduce the commitment towards creditor payments, regularity in paying salaries and meeting other expenses, receipts from clients, any loan-related transactions and investments made or sold.
Additionally, bank statements are the basis for verifying financial transactions since they can be used to cross-verify the information in the Income Statement and Balance Sheet.
If there are any suspicious withdrawals or deposits, the lender must ask for explanations to ensure that there are no fraudulent activities occurring.
Bank statements also shed light on the liquidity management practices of the client, which contribute to the repayment ability.
Financial statements are the backbone of lending decisions since they provide objective, verifiable and quantifiable information, which is necessary for sound decision-making. They also provide the scope to delve deeper using financial tools such as ratios and other computations, which give more perspective about the borrower’s financial health to the lender. They need to be supported with bank statements to facilitate better decision-making.
Lending can turn possibilities into realities. The wrong decisions can also lead to huge losses. Contact Precisa today to know how you can utilise bank statements to make better lending decisions!