Financial Statement Analysis

With a small to medium size business, you are likely to find the company has chosen the cash basis of accounting. While this choice actually gives you a better sense of cash flow, it can be misleading in understanding how profitable the company really was.

First, some background:

Cash basis: 

  • Record income when received
  • Record expenses when paid
  • Advantage...the borrower defers taxes if the company receives the funds after they are earned and it overlaps the year-end.
  • Advantage...this type of accounting is easy to do (checkbook and throw in some depreciation) so a very small business without an outside CPA can easily do their accounting themselves.
  • Advantage...the borrower has some ability to impact the tax level by year-end acceleration of expenses or deferral of revenue.
  • Disadvantage...the borrower pays taxes early if the company receives the funds before they are earned (a deposit) and it overlaps the year-end.
  • Disadvantage...the tax return can be very misleading when their lender is using it to determine credit-worthiness.
Accrual basis:
  • Income is recorded when earned. (Earned but not received shows up on the Balance Sheet as an asset: Accounts Receivable. Received but not earned shows up on the Balance Sheet as a liability: Deferred Revenue.)
  • Expenses are recorded when incurred. (Incurred but not paid shows up on the Balance Sheet as a liability: Accounts Payable. Paid but not incurred shows up on the Balance Sheet as an asset: Prepaid Expenses.)
  • Advantages and disadvantages when it comes to tax returns? Just reverse the ones noted in the cash basis section above.
What is a lender to do?
  • You do not get to choose whether your borrower provides cash basis or accrual basis tax returns. And with a small- to medium-size business, you may not have influence on whether the financial statements they provide are on cash basis versus accrual basis.
  • In the overview stage of analyzing the borrower's tax return (see my business tax manuals, page one of each type of return for the overview list) note whether the return is cash-basis or accrual-basis before you compare the years.
  • If your software calculates accrual adjustments (most of my Ag Lending clients do) leave them in if cash-basis but zero them out if the tax return is already accrual basis.
  • If you have the tax return for anything other than a sole proprietor or one owner LLC you may have the balance sheets per books in the tax return. (There is an exception of the company is small enough.) If the tax return is on the cash basis and the books are on accrual basis you'll spot the accounts receivable and/or accounts payable. And if you know how, you can then convert the income statement (front page of the tax return) from cash to accrual.

So to answer the question, on a tax return is not a red flag.


For a full explanation of cash vs accrual basis and the formula for conversion see Pages 2-5 through 2-7 in the self-study manual: Understanding the Business Scorecard: Financial Statement Analysis. 

For the overview list (including the tip to check on cash or accrual basis) for the 1065, 1120 and 1120S returns see Pages 2-9, 3-13 and 4-13 in the self-study manual: Beyond the 1040: Corporation, Partnership and LLC Tax Return Analysis.

We are adding the section on Financial Statement Analysis to Lender's Online Training with a complimentary eCourse on Balance Sheet Basics.

This joins 4 eCourses on General Analysis Topics, 15 on Tax Return Analysis and two additional on lending.

Here is the list. Those with a gold star are complimentary.

Analysis: Financial Statements

knewstuff2Balance Sheet Basics (25:39 minutes)

  • Three characteristics of the Balance Sheet
  • The difference between personal and business balance sheets
  • Three types of 'value' and which the balance sheet tells you
  • Complete a basic Balance Sheet
  • Balance Sheet Terminology

kgpg_identity2Income Statement Basics (16:05 minutes)

  • How the Income Statement and Balance Sheet fit together
  • The income statement equation
  • Terminology...which gross is gross?
  • How to increase profits
In progress, Statement of Cash Flows Basics, Trends and Ratios, CPA Prepared Statements.

Analysis: General Topics
These topics apply to both tax return and financial statement analysis.

knewstuff2Types of Business Entities (22:58 minutes)

kgpg_identity2Cash versus Accrual Basis (16:20 minutes)

kgpg_identity2Debt, Debt Ratios and Debt Shortcuts (15:47 minutes)

kgpg_identity2Depreciation in Financial Statements and Tax Returns (17:10 minutes)

Analysis of Tax Returns
The topics in this first group apply to 1040, 1065, 1120 and/or 1120S tax returns.

knewstuff2Green Legos, Six Ns and a Map to Tax Return Analysis (16:03 minutes)

kgpg_identity2Capital Gains and Losses...Basics: Schedule D and Form 4797 (17:19 minutes)

1040 Personal Tax Return

kgpg_identity21040 AGI vs Schedule Analysis Method (07:11 minutes)

knewstuff21040 C 1) Basics and Overview (14:35 minutes)

kgpg_identity21040 C 2) Detailed Review (25:01 minutes)

kgpg_identity21040 Schedule F Farming (21:35 minutes)

1065 Partnerships and LLCs

kgpg_identity21065 1) Basics and Overview (17:16 minutes)

kgpg_identity21065 2) Company Cashflow (16:24 minutes)

kgpg_identity21065 3) Owner Cashflow (19:49 minutes)

1120 C Corporations

kgpg_identity21120 1) Basics and Overview (12:34 minutes)

kgpg_identity21120 2) Company Cashflow (20:16 minutes)

kgpg_identity21120 3) Owner and Global Cashflow (10:51 minutes)

1120S S Corporations

kgpg_identity21120S 1) Basics and Overview (15:01 minutes)

kgpg_identity21120S 2) Company Cashflow (20:10 minutes)

kgpg_identity21120S 3) Owner Cashflow (21:20 minutes)

Lending to...

knewstuff2Lending to Farmers (12:34 minutes)

  • Guest author Steve Koehler of NW Farm Credit Services shares insights into how lending to farmers is the same...and different...from other types of commercial lending.

knewstuff2Lending to STRESSED Borrowers (13:27 minutes)

  • Any borrower can become a STRESSED borrower. Guest author Jan McLaughlin CSP of Your Communication Connection helps you stay COOL when things heat up.

If you want access to the kgpg_identity2 subscription courses here is your sign-up page for lender- targeted training at your fingertips.

"The best way to keep your brain on track with the latest updates on business tax return and financials without getting up from your office chair."

Shirley Langford, Loan Officer
Whidbey Island Bank

Lending to a business?
Lending to a business owner?

Either way, you undoubtedly ask for and receive a year-to-date financial statement. Here are eight questions to ask (yourself or your borrower) before you stuff it in the file.

  1. Evaluate the preparer. 
    •    Was it prepared by a CPA or accountant you trust?
    •    Was it prepared by the borrower's in-house accountant who you believe has the skill to provide accurate information?
    •    Was it prepared by the business owner using software that kicks out a statement that looks good but might be 'garbage-in-garbage-out'?

  2. Does the balance sheet balance? (No kidding!)

  3. Ask the borrower if there have been any material changes in assets or liabilities since the balance sheet date. (Ask this question every time you get a balance sheet).

  4. Is the balance sheet comparative? (At least two years. Guidelines now often ask for three. If you have five, even better!)
    •    If not, can you pull out a balance sheet for the same date from your files to compare?
    •    Run your finger down the page and note any major swings in assets, liabilities or capital (equity).
      •    Do they make sense?
      •     Any questions for the borrower?

  5. Does the balance sheet have categories for current assets and current liabilities? If not, it is less likely the preparer is knowledgeable and you do not have the information you need for liquidity analysis.

  6. Do the numbers make sense for the type of business and the state of the economy, the industry and the geographic region?

  7. Consider liquidity. Look at changes in:
    •    Cash balances
    •    Working capital: Current assets minus current liabilities
    •    Current ratio and quick ratio. Compare these to industry averages

  8. Consider leverage.
    •    Calculate Debt to Equity ratio and compare to industry averages
      •    If low compared to their usual ratio or the industry, what is the reason for their caution? This is not a bad thing at all but helpful to understand.
      •    If high compared to their usual ratio or the industry, consider if they have sufficient personal net worth that perhaps it is not an issue. Small business owners often take all the income home and, if more than they need for living expense and personal debt, 'store it' in their own balance sheet.

Time to order our self-study manual on Financial Statement Analysis: Understand the Business Scorecard if:

  •  You are unfamiliar with any of the items listed
  • You are familiar with them but could not explain what they mean to your customer (which tells me maybe you are not crystal clear yourself)
  •  Your software calculates ratios and percentages but you couldn't do them with just the balance sheet and a calculator
Now, more than ever, you need to gather actionable information from the financial statements you are getting from your borrowers.

What are you looking for on financial statements?

What works on auditors may work on lenders

A 2009 study performed by researchers at the University of Massachusetts at Amhurst demonstrated that  auditors are less likely to find manipulated earnings when management directs their attention away from areas of financial statements that contain errors.

The auditors were split into four groups and here was their success at spotting a $450,000 error in an audit where $100,000 was the materiality threshold:

  • 7% of the group that was 'baited' into looking at a section of the financial statements that contained no errors found the big one.
  • 44% of the groups pointed in the direction of minor 'distracting' errors or diversions like a risk alert that an employee with little accounting experience had recently been put in charge of noncurrent assets found the big one.
  • The article in CFO magazine did not share the success rate of the group that was told nothing.

The take-away for lenders and underwriters?

You are more likely to look for bigger problems when you find smaller problems with the numbers, and I think that is a good thing.

And it is natural for a borrower to direct your focus to what is going well. That does not mean they are hiding something else.

But it doesn't mean they aren't! Be careful to do your due diligence on all material aspects of the business and don't fall victim to the fraudsters diversion tactics.
SHORT ANSWER in case you cannot read the entire post:
  • Meet with you small business borrowers for a new needs assessment
  • Visit at least 3.3 times each year
  • Understand their business
  • Demonstrate that you understand their business

The JD Powers and Associates 2009 Small Business Banking Satisfaction Study provides some specific goals for customer satisfaction that can drive profitability. A small business lender can use these as a benchmark:

First...some interesting findings:
  • Nearly one-half (48%) of small business customers have a negative outlook about the economy, which may be impacted by tighter credit conditions.
  • Among business owners who applied for loans in the first six months of 2009, 67 percent of those loans required personal guarantees, compared with 52 percent of loans made three or more years ago.
  • During that same time period, the average time to approve and fund loans made within the past six months has increased to 15.1 days from 13.1 days in the previous six months.

Does your bank assign an account manager to each small business customer?

Overall satisfaction averages 726 on a 1,000-point scale among customers who were assigned an account manager, compared with 669 among customers without a designated account manager.
  • Currently, 46 percent of small business customers are not assigned to an account manager.
  • Only 34 percent of customers who have an assigned account manager report having had a problem with fees and service charges, compared with 39 percent of customers without an assigned account manager.
  • Only 10 percent of customers with assigned account managers report issues with funds availability, versus 16 percent for those without an account manager.

Do your small business customers think you understand them?

  • Satisfaction averages 139 points higher among customers who report their account manager "completely" understands their business, rather than just "partially" or "not at all," yet fewer than one-half (45%) of customers report their bankers "completely" understand their business.
  • Among new customers who report their account manager "completely" understands their business, a thorough needs assessment is conducted 85 percent of the time, compared with only 35 percent of the time among customers who report their business is not understood.
  • Customers who report their business is "completely" understood by their account manager report receiving 3.3 contacts each year, compared with 1.3 contacts among customers who say their account manager does not at all understand their business.
Here is where I got interested. Understanding business is not something you learn in class. It is something you partially learn in my classes on tax return and financial statement analysis because I focus on understanding. It is also something you can learn from mentor lenders, and from your small business clients themselves.

It takes effort and willingness and interest. And according to the JD Powers & Associates, it will add to the profitability of the bank.

How does this impact bank profitability?

The study found that higher satisfaction among small business customers has a substantial impact on a bank's financial performance. Overall, highly satisfied customers (satisfaction scores averaging more than 800) generate $4,107 of annual net revenue each on average, which is $675, or 20 percent, more than less-satisfied customers.

Need profit? Keep those small business borrowers highly satisfied.
  • Is it time for a(nother) thorough needs assessment?
  • How often do you visit your small business customers? Perhaps a good 2010 resolution is at least 3.3 times! <grin>
  • Time to reach out?

I predict the 2009 tax returns will be filed earlier rather than later. Why? The congress has liberalized the rules for carrying back Net Operating Losses. If the business paid taxes in any of the prior 5 years, they can carry back the loss to any of those years. Tax refunds anyone?

If that is the case for some of your business borrowers, you will soon be including 2008 and 2009 in your analysis, the worst years of the recession. So here are your questions:

  1. How do you (or will you) qualify a borrower for a business loan when the two or three most recent year's tax returns or financial statements do not support the loan request in terms of required debt coverage ratio and other financial requirements?
  2. How do you distinguish a business that has done poorly from a business whose owner chose to forgo profits to keep their business recovery-ready?
  3. If the business owner chose not to pay themselves during the downturn in order to keep their staff, continue to market in a downturn and otherwise keep the business as strong as possible, how will that impact your analysis of them as a guarantor? (They may not 'qualify' even if their business is now doing well and back to paying them.)
  4. What compensating factors are going to make up for a recent two or three year's financial performance that is not sufficient to qualify for the loan?
  5. Are loans to continuing businesses going to need to be assessed more like loans to start-ups?

What do you think?

In the mood to be inspired? Read on. Not in the mood, scroll to the bottom of the post for some 'cost' definitions and why they are important.

If you have not yet presented a Junior Achievement class to school kids, you have been missing out. I was struck as I read an article aimed at business start-ups at how well the 7 year old kids had these concepts down.The article made the case for clearly understanding start-up costs versus continuing costs.

Wants or Needs

Picture this...
The first question:

Is this puppy a need or a want?

Most of the kids held up the 'want' card, but one held up the 'need' card. I had already explained that every answer was right, but I was curious.
Linda: "Joseph, you are right, of course. But I wonder why you chose 'need'?"
Joseph: "If I was blind and that was a seeing-eye puppy, it would be a need."

Just in case you think Joseph was a precocious child and unusual in his wisdom, let me adjust your assumptions. The next picture was a winter coat.
WinterCoat.pngThis time it was Amber who held up the 'want' card when everyone else selected 'need'.
Linda: "So, Amber, why would a winter coat be a want instead of a need?"
Amber: "Because I already have one. I needed the first one but I do not need a second one."

Start-up or ongoing costs...

I held up the 'puppy' poster again and asked what they thought they might need to budget to buy and keep this puppy. I explained start-up costs and ongoing costs.

Again, pretty sharp answers. In addition to what she could see in the poster, Sheila suggested we budget for veterinary bills. The students were pretty much in agreement until we came to the collar.

Most said it was start-up, but Jason pointed out that the puppy would grow and it would be too tight soon. Same for the 'puppy-house'.

7 year old kids get costs behave.

How costs behave is critical to budgeting...for a puppy or for a business.
  • Whether they are start-up or ongoing
  • Whether they are variable or fixed
  • Whether they are a need or a want

Are your business borrowers smarter than a 1st grader?

I'd settle for 'as smart'!

Cost definitions and why they matter

Here are a few cost analysis definitions and uses for your review:

  • Variable costs vary with activity level. Inventory, supplies, and contracted labor are good examples.
  • Fixed costs do not vary with activity level. Lease of space is a good example as long as the company does not get so big they need additional space. Because of that 'as long as', we talk about fixed costs in the relevant range...the likely activity range the business will encounter in the period we are considering.
  • Mixed costs have some of each. For example, at some shopping malls the lease amount is a fixed portion plus a percentage of revenue. If your borrower uses temporary help, then labor costs include the fixed portion for their regular employee wages plus the variable portion for the temp workers.
  • Cost of goods sold is the cost of items held for sale. That includes work-in-progress and raw materials if a manufacturing concern.
  • Gross margin is revenue minus cost of goods sold. The gross margin (sometimes called gross profit) is the amount left over after those direct costs available to cover general and operating costs and provide profit to the owners.
  • Contribution margin is revenue minus variable costs. It is not shown on a typical financial statement. The concept is critical, however, because if the price per item is dropped to spur sales activity, but dropped below the contribution margin, the business will lose money on each item sold. They may do this as a loss leader on purpose. But if they do this because they don't know any better, I think the 7 year old kids could help explain it.
When your borrower is projecting future growth, or a return to profitability after the 'great recession', steer your conversation towards a discussion of costs to get a feel for whether they understand how their business costs behave. The better they understand this, the more likely their projections will make sense.

alphabetsoup.jpg Lender Lingo makes talking amongst ourselves quick and easy. It can lead to confusion with borrowers, though.

Confusion in lending agreements is a recipe for disaster! (See how nicely I tied in that soup metaphor?)

Here are some letters I hear all the time. This list is not for you, it is for your borrowers! Don't use these shortcuts around your borrowers unless they know them, too.


Debt to Income...the ratio we use to determine if the personal debt of the owner/guarantor is more than they can afford based on their income. Heck, we don't even mean income in that ratio. We are looking for cashflow.


Debt Coverage (or Debt Service) Ratio...This is the flip of the DTI. Or if you liked algebra in high school, you might remember it as the reciprocal. It is used in small business, commercial and commercial real estate lending. It compares the Cashflow Available to Pay Debt to the debt. A 1-to-1 ratio would mean they just have enough cashflow to pay the debt. We used to want 1.2-to-1 (a 20% cushion). These days we are more likely interested in 1.25- or 1.3-to-1.


Home Equity Line of Credit...otherwise known as the substitute for charge cards or personal savings before the sky fell and people needed to start living within their means. (Oh, did I write that out loud?)

I am not asserting that every home equity line of credit was used irresponsibly. Some people used it to remodel their home or buy a needed vehicle. Or perhaps pay off an unexpected medical bill.

The challenge with the HELOCs was the drop, in some areas precipitously, of home values. With the combination of a mortgage that might have been 90% LTV (see below) and a HELOC that brought the total loans secured by the home to 125%...well, you can see the problem.


Line of Credit...not to be confused with the HELOC. This is typically for commercial or business use. The anticipated use is usually to gear up for seasonal activity (buy inventory for holiday sales) or to take care of a short-term need (such as a major roof repair before refinancing a building).

There is a lot of pressure on lines of credit (often called operating lines) as business borrowers' fundamentals drop, they miss loan covenants or the value of the collateral is impaired.

The lines of credit are expected to be at zero at least part of the year. If the borrower cannot retire the line when promised, the lender has the option to extend it, term it out (set it up for payments that will retire the line within three to five years), or take the collateral.


Loan to Value...the relationship between the amount of the loan and the value (fair market) of the underlying collateral. Once again, reductions in property values caused havoc with LTVs.

Besides, when the sun was shining and someone convinced too many other someones that real estate values would go up forever, lenders were comfortable with up to 100% LTV. No longer.

  • What other terms are you using that your borrowers do not understand?
  • Do you think they'll ask if they don't understand you? Actually, I think most of them will not. Scary but true.
Bernanke and Obama may say the economy is in recovery, but your travel (and possibly your training) budget is still in critical care.

If you or your lenders are traveling over an hour to get to my sessions, or my schedule programs are not at a good time, I can come to you!

One lender may be all it takes...

With our 'local option' I have no marketing or meeting space costs so I can confirm our two-day tax return analysis training and/or our one-day financial statement analysis training with as few as 5 confirmed attendees from any combination of banks, credit unions, mortgage companies or other creditors in your area.

Just one lender from your company may be all we are looking for. And if you have 5, it is a go!

Here is how it works:

  • Call 360 455 1569 or email and let us know how many lenders you would like to send if we come to you and the dates work.
  • We'll follow up and between our contacts and yours we'll find that first five to get it on our schedule.
  • Once we are over five paid, the bank or credit union that provides us the meeting space gets one complimentary registration.
  • We offer a discount if your RMA or CU League chapter helps your members by putting the word out.
We are actively working on a 'local' for Eugene, OR and Santa Rosa, CA. And we have feelers out for San Luis Obispo/Santa Barbara and Bakersfield/Fresno.

If you are staying overnight to attend this training, we should be coming to you, don't you think?


  • Get more from your training dollars
  • Keep your lenders home
  • Schedule training according to your calendar, not mine
  • Get ready for the tougher lending environment as the worst of the recession years come into your analysis


My calendar has room for two locals each month through December. Then things start getting busy!

Call or email Kimberly to see if there are already inquiries about your area or to get the ball rolling.
Heck, even if your financial institution has money to lend, you'll be doing your business borrowers a service if you help them see the additional cash they may have tied up in working capital right now.

In a recent article in the Portland Business Journal, two investment bankers, an attorney and a CPA responded to the question:
With the credit crisis continuing to limit bank lending activities, what alternative means should businesses consider for obtaining financing?

Three of the four mentioned an operating cycle focus. Let's look at how changes in the operating cycle can free up cash. Here is a slide from my credit training on financial statement analysis:

Operating Cycle:

Operating Cycle.pngBe the business owner/manager for a moment. Imagine that you can 'turn' your cash back into cash four times a year. In other words, it takes 90 days from the time you pay your supplier for your inventory for you to sell the goods and collect the receivable. What if you could do that in 60 days instead? That would be 6 times a year instead of 4 times a year. Assuming everything else remained the same, you might be able to increase gross margin by 50%!

Or, in this environment, it is more likely that you could:
  • free up cash to help cover for reduced revenues because let's face it, everything else is not remaining the same.
  • increase your capital cushion.
  • improve your debt coverage ratio which would make your banker more comfortable.
  • deal more effectively with the economic uncertainty as you wait to see how soon the recession will be over, and how long it will take to recover.

With less availability of credit, it is no wonder that our four experts suggest looking to this source...the business itself.


Let's look at the payment for the inventory first.
OperatingCycleWaitLonger.pngCan you wait longer to pay? This could be as simple as not paying early, although I am pretty sure your business borrowers have thought of that one. Perhaps the business borrower can approach suppliers and ask for better terms. And if they are in the habit of paying early to capture a discount, they might reconsider if that is the best choice now.

Talking to the suppliers is a great idea for many reasons. Payment terms is one, just-in-time inventory might be another.


Still in the mindset of the business owner/manager, consider if your inventory mix is right for our current situation. Have you revised what you are buying, or the quantities, for what is selling best right now? Have you considered if some of the sidelines you had wandered into over the last few years are not the core business to attend to right now?

Your customers may never be as understanding as they are now if you only carry red, blue and green and no longer carry chartreuse.

So add to the call list...if talking with your suppliers will help you negotiate payment terms and tighten the delivery timeline, talking with your customers will help you be sure you have what they need when the need it.


OperatingCycleSales.pngSome tried and true ways to accelerate sales are ...well....sales! If you have slower moving inventory, would it make sense to offer a discount? What about encouraging cash sales instead of credit. In my analysis training workshop, I love to show how a drop in days in receivables can be solely related to a shift from credit to cash sales.

For those of you who are knowledgeable about financial statement analysis, you may be squinting your eyes as you read that last paragraph. The reason it is true is because the banker does not have 'credit sales' as a numerator and uses 'total sales' instead. And if this paragraph made absolutely no sense to you it is time to study up on financial statement analysis. '-)

CAUTION: Do not encourage a business owner to drastically cut prices to move inventory without serious consideration to the impact on their brand. A short-term solution to the credit crunch could turn into a long-term disaster if the business brand or image is damaged as they come out of the recession.


OperatingCycleReceivalbes.pngOnce the sale is made, if on credit, we still have to collect. Staying in touch with your customers is vital here again. Offering discounts for early payment may help, although many of your customers are also trying to conserve cash. If a payment is late, be on the phone immediately. Consider asking if they received the product, or how it is working for them. It will have the same impact as asking for their payment but is a much friendlier overture.

How are they doing and how can you tell?

In financial statement analysis, we talk about working capital, operating cycles, Days in Payable, Days in Inventory and Inventory Turnover, Days in Receivables and Receivables Turnover. These are all ways to see how the business is managing the operating cycle and if there is tied up cash or lost profits in a cycle that could be accelerated.

Help your business borrower see these options and you'll not only help them through the recession, but you'll be more likely to keep them as a customer.

Need a brush-up?

Need a brush up on financial statement analysis and operating cycles? It is covered in my self-study resource:  'Financial Statement Analysis: Understanding the Business Scorecard' .

What are you suggesting as an alternative to bank financing?