In addition to the "Five C's," a prospective lender will use four primary financial statements to make a credit decision.
A Personal Financial Statement
Indicates your net worth. Each partner or stockholder owning a substantial percentage (for example, 20 percent or more) of the business should submit one. A personal financial statement is important to the lender, particularly if you have never received financing for your business before, because it gives the lender evidence of personal assets you could pledge to secure a loan.
A Balance Sheet
Provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of your company's assets, or what the company owns (including its cash), and the company's debts, or liabilities (generally loans from others). It also shows the capital, or equity, put into the business.
A Profit and Loss Statement
Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses.
A Statement of Cash Flows
Presents the sources of cash in your business—from net income, new capital, or loan proceeds—versus the expenditures, or uses of the cash, over a specified period of time.
It's at this stage that you will appreciate having an effective accounting system. Without this system, you won't know if you are profitable or not, let alone if you are liquid enough (simply put, have enough cash on hand) to pay for the next order of merchandise. A good system also will help you track your company's growth and anticipate future cash needs.
Another tool the lender will use is financial ratio analysis. Ratios permit review of a company's current financial performance versus that of previous years. In the same way that a medical checkup tests one's heart, lungs, and changeable factors such as body weight, an analysis of a company's financial performance considers the status, changes, and relationships of critical components of a company's health.
The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.
Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company's "peer group" of similar companies within its industry. To find out what the benchmarks are for your type of business, you may refer to guides published by Robert Morris Associates and others.
The following section presents some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover.
Your lender's analysis also may include ratios specific to your particular industry. For additional information on financial analysis and calculation of ratios, check with an accountant, your lender.
Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its "after-product-costs" cash.
Gross Profit Margin
One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin.
Operating Profit Margin
Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and "extraordinary items" such as the sale of property or other assets.
Higher profitability from one year to the next is generally considered a good sign for a company.
How much cash does your business have on hand for immediate use?
The quick ratio shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.
The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.
The leverage ratios measure the company's use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.
The most common leverage ratio is called, simply, the debt ratio:
The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.
It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Those sales you make on the customer's promise to pay at a later date (also known as credit sales) may not actually produce cash for 30 to 60 days. You can get squeezed if you don't understand this cycle and find that you have to pay for new supplies before your customers have paid you.
Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.
The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.
Collection Period Ratio
First, the collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work purchasing more inventory or paying for current orders; so the lower the number, the better.
Days to Sell Inventory Ratio
Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you've accurately forecasted the demand for your product. That way excess inventory isn't accumulating on your shelves and adding to costs.
Days Purchases in Accounts Payable Ratio
The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.