Why 3 years of financial statements??

Did you ever wonder why your banker asks for three years of financial statements when you begin a credit relationship with them?  Do they really look at all this information?  (yeah, they really do)

Banks do something called trend analysis.  Trends for a banker are the changes in liquidity, leverage, profitability or activity (how quickly they are turning receivables or inventory is activity) over a period of time.

One year of financials have nothing to compare.  There are no trends.  Two years are considered a coincidence.  Maybe a change happens between the two years, but will it happen again?  Three years is considered a trend by bankers.  The reason for that is the change happened not once, but twice.

For example, if your gross profit margin went from 30% year 1 to 25% in year 2 to 20% in year three, that's a trend.  Bankers will do this trend analysis on an annual basis when they do the annual review of your line of credit or mortgage or other term loans.  Trends can be positive or negative and both are reviewed.  The reason they are reviewed is because the bank wants to know if the risk of lending to your company has changed either positively or negatively.  They are required to assign a risk rating to your loans every year.

I suggest getting on the same page with your banker by doing your own trend analysis and find out what your bank might be thinking.  What do you think?

The Skinny on Loan Covenants

Covenants, by definition, are promises made by two parties to each other.  Banks use covenants to communicate what's important to them in a banking/lending relationship.  Most business owners go along with the covenants because they want the loan.  At times, the mutual promises made seem to get lost in the transaction.

Most covenants seem to cover issues pertaining to ownership/management and to financial performance.  Given the current economy, more attention is paid to the latter.  Financial covenants can be a line of credit payout for 30 days.  You and the bank promise each other that the line of credit wasn't a permanent investment in the company.  The ability to pay the bank out for at least 30 days is proof of that promise.  Covenants can also be used to measure leverage ( a debt to worth covenant) ie total debt divided by total equity.  This covenant protects the bank and the business from excessive leverage.  A cash flow covenant (cash flow divided by current maturities of long term debt) shows both parties that the company has adequate cash flow to cover loan payments with a cushion, typically 25-30%.

Given the current economy, banks are placing more emphasis on loan covenants due to their capital constraints and loan quality issues.  Your line of credit may be coming up for renewal or your mortgage loan may be maturing.  It would be a good idea to know what loan covenants exist in your loan commitment and did you meet them.  Since loan covenants are promises made by both parties to each other, you would expect any broken promises could trigger discussions between you and your bank.  Be prepared!

Real Estate Values, do you have a loan to value exception?

This is a common question.  Most banks in the past have financed 75-80% of the value of the property.  Some have financed more, few have financed less historically.  Many business owners are experiencing mortgage maturities and are seeing dramatic declines in value.  When the loan to value exceeds between 80-85%, your bank may notify you that there is a loan to value exception.  Loan to value guidelines are set for banks under the Financial Institutions Real Estate Act (FIREA)


Banks are required by law to order an updated appraisal whenever the mortgage has a maturity.  The appraisal has three approaches to value.  The cost approach-how much does it cost to build the structure in the current market.  The sales comparison approach-what are the current comparable properties selling for in this market.  The income approach-taking the net operating income of the project and applying a capitalization rate.


Many banks feel that two of these approaches are not currently relevant.  Since there is little to no new construction going right now, the cost approach is not applicable in most circumstances.  Many of the current comparable sales are either short sales or bank foreclosures, it could be argued that the sales comparison approach does not give relevant data either.


Most banks are using the income approach to value.  This approach takes the current lease income (with a slight reduction for potential or current vacancy), subtract operating expenses taxes, insurance and other expenses and come up with a net operating income (NOI).  With that number you apply a capitalization rate (the return most investors are looking for in the current market).  Cap rates are subjective, but it seems that banks are applying cap rates between 9 and 10%.  Some higher and some lower.


Because of the current circumstances going on in the market, most banks feel the income approach to value is most relevant.  Specifically, a commercial property is valued based on the income it generates.   What do you think?

The 80-20 rule

You've heard of the 80-20 rule.  20% of the people do 80% of the work and so on and so on.

The same applies to financing your business.  When you look at how you finance your company (the assets) make sure that you take on at least 20% of the financing risk (equity) and ask your creditors not to take more than 80% of the risk (your bank and suppliers)

If your creditors are taking more than 80% of the risk and they have no upside, you will start getting push back or will have difficulty finding financing.  After all, you have little to no skin in the game and all the upside.

Having a hard time finding financing, compare your company against the 80-20 rule.

I'm grateful

I've discovered that it's hard to be in a bad mood when you're grateful.  My mother (and her mother) told me to be sure I count my blessings daily.  I have moments of gratitude, but also moments of anxiety, worry and fear.  Kids in college, elderly parents, funding retirement (will I retire?)

I started McDermott Financial Solutions in April 2009 to help business owners with banking issues.  The banking landscape has never been more confusing.  This is a time when most business owners need a banker more than ever.  I titled this article "I'm grateful" because in 2009  I had the pleasure of serving 35 business owners with banking solution help.  That's about 1 client every week. I was shocked at the number.

The past is over and 2009 is done.  I have hope for the future.  In 2010, I hope to serve 70 businesses, double the number in 2009.  However, this is not the past or the future.  I intend to enjoy this current moment with an attitude of gratitude.