Sometimes, financial statements can inadvertently tell the wrong story leading to misunderstandings, funding loss, and potentially legal consequences. We’ll look at a few important factors that make sense from a business perspective but could alter the story being communicated on the face of financial statements. Through this analysis, we’ll share how you can be prepared to tell the right story.
A balance sheet presents a snapshot of your business’ assets, liabilities, and net assets at a particular point in time. How your financial position is presented at that point in time is immortalized for lenders and other users of those financial statements—what happened before and after that balance sheet date is a mystery to them. Therefore, any odd or non-routine year-end transactions can paint a misleading picture of the financial health of your business. As lenders and other users generally analyze year-over-year trends, that incorrect picture can be presented for a long time.
Here’s a few examples of balance sheet considerations:
Unusually large contracts may present more risk. For example:
If your business doesn’t maintain that level of sales in the following year, this may convey a downward trend in revenues. Trends do matter almost as much as the numbers and users of financial statements prefer stable or improving trends. This is not to say that you should avoid unusually large contracts or sales, it’s just important that the lender understands the resulting “decline” in revenue that may occur in subsequent years, which may actually be a normalization rather than a decrease.
Secondly, one-time expenses, such as office renovation, product development, or temporary hire, will have an impact on your business’ bottom line. Any significant, one-time expenses should be presented separately in the income statement (where appropriate to do so), or in the financial statement notes, as well as in separate communications so that the lender can identify costs that are unlikely to recur. Any borrower should also be aware that with one-time expenses, lenders are concerned with cost containment and sustainability. Businesses should try to understand their lender’s concerns and provide any additional information separately that might be helpful in reducing those concerns. For example, a lender may find it comforting to see your business prepare a strict budget for a particular project and that you're regularly tracking its actual expenses against that budget to manage and mitigate cost overruns.
Thirdly, discretionary expenses and owner perks reduce a business’ profits and readers of the financial statements may not be able to directly determine such expenses from the financial statements themselves. A business should consider disclosing significant discretionary expenses and owner perks to the lender so they can find out which expenses the business could forgo if times get tough. Such disclosure would generally not be included in a business’ Accounting for Private Enterprises (ASPE) compliant financial statements, but rather in a separate communication. Further, lenders often look to see that the owner in an owner-managed business is taking a salary or other form of remuneration. If the owner-manager is not paying him/herself for their work, this can cause lenders to speculate that the owner believes the business cannot support that expense—which is cause for concern.
If your business provides a range of products/services, it’s common to generate higher margins on certain products/services and for the underlying sales mix to change year-over-year.
If your business' profit margin increases, the lender will want to understand whether the increase is sustainable. For example, did your business cut costs in a particular area which could be detrimental to its reputation or the quality of its products/services?
Alternatively, your profit margins could decrease because your business is selling more of the products/services on which it earns a lower profit margin, or it started selling new products/services with a lower profit margin, or it has cost escalation, and so on. When there’s a decrease in your business’ profit margin, the lender may suspect that it’s buying market share, facing greater competition, or lagging behind cost increases with its pricing structure.
To tell the right story, it’s beneficial for you to prepare schedules to your business’ financial statements to be able to separate its revenue and cost data amongst its different products/services.
If a lender doesn’t require your business to provide audited or reviewed financial statements, you may opt to prepare financial statements on a cash basis, whereby revenues will be reported as / when cash is received from customers.
If a lender requires your business to provide audited or reviewed financial statements, they must be prepared in accordance with a generally accepted accounting framework such as ASPE, which requires application of the accrual method of accounting. Revenue would be recognized when it’s earned and the amount of revenues to be recognized would depend on the type of sales arrangement in place (such as the percentage of completion basis, time and materials basis, completed contract basis, etc.).
In many cases, the accounting for a sales arrangement is very sensitive to specific terms and conditions in the underlying customer agreements. Therefore, a small change in the contract terms could result in a significant change in the amount of revenue to be recognized. If a lender doesn’t understand the cause of the change in your business’ revenue, significant annual changes in top-line revenue and/or bottom-line results, it may trigger concern.
Even the strongest and most stable businesses are bound to encounter a difficult year at some point, whether supply chain disruption, resource constraints and shortages, cost escalation, or several other challenges that can make it very difficult to segment customers or modify pricing structures in short order.
While a bad year is obviously going to be a concern for a lender, the information they need most in these instances won’t be easily obtained from financial statements. Ultimately, a lender needs to understand whether a business is planning to address and rectify the issues or matters that have caused any problems to arise. It’s important to be prepared to have these conversations and provide supplemental information or analyses to lenders.
The goal of tax minimization or tax deferral often conflicts with the goal of external reporting (or maximizing profitability). Lenders and other users of financial statements generally want to see your business’ actual net income potential and not an understated amount, especially when your business is in growth mode. Therefore, you’ll need to balance the goal of tax minimization with financial reporting. If your business’ lenders are keenly focused on profit metrics, communication disconnects will arise and need to be managed.
In addition to the numbers on financial statements, lenders also consider the following when assessing whether trouble may lie ahead for a business:
Often, management and owners are so involved in the day-to-day operations of their business that they don’t recognize the warning signs that may be visible to a lender or another independent party (such as their accountant). It’s very important for management or owners to be actively involved in working with their strategic advisor to recognize potential problems or signs early on in order to have the greatest chance for remediation.
We can help your financial statements tell the right story. As trusted advisors, we’ll work with you to develop a clear and accurate picture for lenders to fully understand your business.
Visit our Helping businesses gain financial clarity and confidence hub for more insights.
