Can I safely use year-to-date financial statements in my analysis?
We get the year-to-date financial statements in addition to the most recent two years tax returns. If I average the two-years tax returns, the borrower does not qualify. But if I factor in the year-to-date financial statements, the borrower does qualify.
In a previous question on how to qualify borrowers as historical information get’s worse I gave a few suggestions for using year-to-date financial statements.
As to your specific question about including YTD financial statement info in your averages, you need to check your guidelines. Even if guidelines do not allow that calculation, YTD financial statements help tell the story.
If you absolutely need the year-to-date numbers to qualify your borrower or if your judgment about the credit-worthiness of the borrower is heavily influenced by those statements, here are some additional ideas.
- Consider whether using an average from the two year’s tax returns is not the best guess as to what is coming next.
- Perhaps the year-to-date financial statements, if consistent with the most recent year, give you a good reason to use the most recent tax return instead of the average.
- Ask for the year-to-date financial statements broken out by quarter or by year, with financial statements for the previous year-to-date broken out the same way.
- This allows you to see what the trend is and how seasonality impacts the business.
- If the business was already recession-challenged in the earliest of the tax return year’s you are using, consider asking for one more year back.
- Your goal is to see what a ‘normal’ year might look like.
- Do not assume, however, that this specific business will be like it was pre-recession.
- Consider whether you have the training in financial statement analysis to spot problems or concerns.
- Many lenders have followed guidelines in requesting YTD financial statements and putting them in the files. Some of those lenders do not yet have the training and/or judgment to include them in the analysis.
- Be cautious if you have cash-basis tax returns and accrual-basis financial statements.
- If you average them together, you are likely to completely lose revenue earned, but not yet received, in the tax return year.
- Have a conversation with the borrower about what is happening next in their business.
- Conditions (one of the six C’s of Credit) have been so unsettled that the borrower’s assertions as to their plans, how they are continuing to adjust to the changed landscape, and what their back-up plans are will be crucial to your understanding of the risk of this loan.
More time required…
If you are thinking this is going to take more time than you used to have to spend, you are right. But from the conversations I am having with Chief Credit Officers and seasoned lenders, from banks and from credit unions, it is time we took a bit more time.
There is no upside to making a loan that the regulators are going to challenge. And the regulators are not in a flexible mood…yet. There is no upside for them to have a bank or credit union ‘go down’ on their watch.
Underlying principles remain…
In lending, there are still some underlying principles that either are business-as-usual or that we are getting back to:
- Understand your guidelines
- Understand your borrower
- Bring your best judgment to the situation