The Top 10 Warning Signs for Business in a Recession: Lenders are Watching
Linda Keith, CPA is an expert at training commercial lending officers how to read financial statements and lend money to business borrowers safely. She has an comprehensive training program and has provided loan officer training in hundreds of notable banks, credit unions, mortgage companies, and other lending institutions. At my request, she has graciously written an exclusive article for us about what lenders need to be focused during and after the recession. This is valuable to business owners because it gives them a rare insight into the lending process. Linda may be reached at Linda@lindakeithcpa.com. Remember as you read this to imagine yourself on the other side of the lending table from yourself!
The Top 10 Warning Signs for Business in a Recession: Lenders are Watching
By Linda Keith, CPA
In good times, a business owner may have delegated ‘understanding’ the financials to the accountant. The lenders kept renewing your line of credit. If there was something you should know, your accountant would point it out, right?
In this environment, business owners need to spot signs of trouble as early as possible. Ask your CPA to work with you on this. If any of these ten warning signs show up, have your explanation ready for the lender next time you go in for a loan.
1) The owner is taking out more than the company can afford.
This seems an obvious red flag and that’s a mistake. Perhaps the company sold an asset no longer needed, received an insurance settlement or landed a one-time contract.
If owner compensation seems more than operations can support explain the source to the lender and show adequate continuing liquidity in the business and/or personal financials.
2) The owner is taking less out than the company can afford.
In most closely-held businesses, the company makes the money and the owners take it home. Period.
If the owners leave money on the table, it could be because the company is getting ready to expand significantly. Expansion periods tend to be riskier than stable periods. Even in this economy, some businesses are taking advantage of opportunities to snap up other businesses or their excess inventory.
Of course, this may simply indicate a frugal owner who can live on less than her normal earnings and is choosing to shore up the business. Be ready to explain.
3) Legal fees have increased dramatically.
A lawsuit may be in progress. Or professional fees could be accounting costs or other legal services such as intellectual property protection. Which is it?
A contract dispute in which the company will lose money is very different than a dispute in which you’ll lose the right to manufacture your best product. Answer this question before the lender asks: What is the most likely and the worst outcome and how will the company handle it?
Perhaps the biggest downside of a lawsuit right now could be the distraction it causes. Have you considered settling?
4) Discretionary expenses have dropped significantly.
Have repairs dropped noticeably when the business has not replaced older equipment? Is insurance down? This may look bad but could be good.
Did you find costs to cut back without harming the business? Coming out of a recession the 'smart' businesses may be running leaner for this reason. Take a good look at any costs that have dropped significantly, especially as a percentage of revenues. Explain to the lender.
5) Taxes and licenses do not seem to be sufficient given the wages paid.
Payroll taxes vary, but run between 10% and 40% of wages. It is a very quick check to compare 10% of wages to the figure in the taxes and licenses line. Your lender knows that if they and the IRS are in line to get money from the business, the lender is not in front!
6) The owner is writing off significant, personal expenses.
Many people, including some lenders, think this is one of the ‘perks’ of being in business for yourself. When it is blatant and excessive, it signals a willingness on the part of the business owner to mislead third parties (the IRS) for financial gain (less taxes).
The lender is a third party and the business wants money from the lender. Sounds like a third-party situation with the potential for financial gain to me. What signal are you sending?
7) Cash reserves are low or have dropped.
Watch for a significant drop in cash balances or amounts that do not appear adequate. Understand why it might be okay and what compensates for it.
For example, C-Corporation owners often take compensation out at the advice of their tax professional to bring the company to zero profit for tax reasons. The owners of pass-through entities like LLCs and S-corporations may put excess distributions into personal liquid assets and not focus on company liquidity.
If the guarantor’s personal balance sheet shows good liquidity and net worth, many commercial lenders do a global analysis of the business and the primary guarantor combined. Be prepared to provide more personal information, more frequent financial statements or CPA ‘reviewed’ instead of ‘compiled’ statements.
8) The operating cycle is slowing down.
As cash balances drop, a business becomes more vulnerable to the unexpected. In a recession, there is more unexpected to cope with.
Watch days in receivables, days in inventory and days in payables closely and take quick action if the ‘cash cycle’ starts to spread. Create a 13-week cash flow and let your lender know you are doing so.
If you are not sure how to monitor/manage your operating cycle, ask your CPA. Communicate closely with your customers to be sure you are producing what and how much they need and with your vendors to be sure you get what you need.
9) The business is selling off equipment that is critical to operations.
The lender should check Form 4797 for ‘Gain or Loss on Disposal of Business Assets’. Is this just the normal selling and replacing of equipment? If a business is selling off critical items and not replacing them, it may mean cashflow problems or a significant change in the business.
During a recession, some businesses may sell underutilized equipment with the plan to lease it when needed. This may be a very good move. Communication between the business owner and lender is critical so that what is a good move does not look like a desperation play.
10) Ownership has changed.
For closely held companies, continued success correlates closely with the experience of the owner/managers. In a recession, management history is more important especially if current management has successfully made it through a previous downturn.
If your management has changed, be ready to provide the lender with evidence of past success of the new management.
The Subtle Warning Signs may be the ones that sink you
I did not add dropping revenue to my list because you will notice that one. I am more concerned with the subtle warning signs you might miss but your lender might not.
Set up systems to catch these as early as possible. Work with your accountant to better understand and predict them. If you are putting in a loan request, address them.
When credit is tight, each loan is tougher to put through for the business owner and for the lender. Understanding and explaining ‘warning signs’ up front will help smooth the way.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
You may contact Sam directly at: sam@lesliethacker.com
or follow him on Twitter: SMBfinance
EXTRA: If you have questions for Sam regarding business financing, the credit market, and similar issues, please send an e-mail. Your questions will be recorded and Sam will answer the best ones in his podcast show.
