Credit Analysis 101Jun 09, 2021
Very good, good afternoon everyone, thank you very much for joining us in today's session. Credit Analysis 101. I'm Libby Biermann and I work on stage and I want to go over just a few housekeeping items before I turn them in first for today's presentation. Everything, we have made the slides available to everyone who joins today if you go to the control panel of your GoToWebinar gray screen that appears at the top right of your screen, there is a section called chat or questions and within those sections there will be a link where you can download the slides.
We will also follow up with everyone who registered for today's session, both those who attended and those who were unable to attend, with a copy of the slides in an email, as well as a copy of today's session. recording so if you were looking for the slides later I wanted to be able to share them with the next ones they will be in your inbox but this afternoon the last item is for questions and inside the dashboard there is also a section where you can ask a question to our presenter, we'll make time at the end of today's session to go over some of those questions.
If we don't have time to go through them all, we'll follow up individually by email to anyone who asks questions, so please feel free. It's free to send them during the session as they come to you, but we'll most likely receive them near the end of the session, so here at the conclusion of the webinar or later via email, and before we actually get started with the meat of the presentation, I want to ask if you ask questions for everyone in attendance today, the idea here is that Peter will be able to make you choose better among the audience and then tailor the conversation and resolve the content closer to those needs, so the First question is what is it? your role in the institution and you should now see that question appear on your screen and allow you to select one of the answers that best suits your job, the others available if none of them are actually close to your job, but if there is a. as close as you can go ahead and select that and I'll give you just a moment to go ahead and select your position.
It looks like we're about 85% of the is code and I'm going to go ahead and close those folds now. and we will share the results, approximately 63 percent of today's attendees or
creditanalysts and we also have a good mix of others as well as loan officers, so welcome everyone and Peter will look forward to speaking to you more directly now. I'm going to ask another quick survey question and this one is asking about your level of experience with
analysisand you should see this question on your screen now, so how would you describe your level of experience with credit
Little to no basic understanding, intermediate understanding or experts, and I know it. This isn't exactly a clear science, but you can choose the label that best describes how comfortable you are with this, which will again help us tailor today's conversation to be more appropriate. It looks like about 75% have been able to vote, so I'll give you just a second more. Well, we'll go ahead and close that poll as well and share the results. It looks like about 40% of you have a basic understanding or an intermediate understanding So I guess we don't have two new people to the area, but we're also missing some of the experts that you'll tailor the conversation with to meet those needs, and then the final survey question is: how are you currently doing?
How are you currently handling your credit analysis needs? This is just to get an idea of the type of solutions that are currently used, so the options are Excel spreadsheets, either a good model or perhaps one that you have purchased from someone else, a third-party software solution that can be a web-based solution or a desktop solution that you have specifically for credit analysis a consulting company if you outsource your credit analysis or if you don't know exactly what they use your institution, you can choose the latter option. Well, it seems like most people have had the opportunity to share. their answers.
I'm going to go ahead and colorize these surveys and share those results as well, so about half of the audience today uses a third-party software solution and a close 40% uses an Excel spreadsheet, so they use that internally. . models to accommodate many of the same things and now before we dive into the content just a little bit about our presence our presenter today on stage works so Peter Brown is a senior consultant for stage work and works with our banking and credit union clients. or both the implementation of its president Alice's program and training in best practices.
He also does a very good job hosting webinars like this, as well as product webinars to ensure our customers and prospects can understand the solutions and content. as much as possible, so we look forward to speaking with you today. Some talked a little about their experience. He previously worked in technology and financial services businesses and also successfully ran his own small business, which helps in small business credit analysis based on us. We'll talk about today and then quickly talk about stage work. Sanders has been working in the financial institutions market since approximately 2006 providing solutions for credit risk management, stress testing, risk rating load management or portfolio management, as well as provision for losses on loans and leases, as well We have started hosting frequent webinars like the one you are attending today, once a month or more than twice a month on topics like credit analysis or a triple L if you visit our website for banks, which is stage berg analyst comm, You'll be able to learn more about the solutions, but also register for webinars like this one and download lots of free resources we make available, including whitepapers, downloadable templates, and videos to help you. with some of those content scenes as well and with that I'd like to go ahead and hand it over now so Peter can go over the agenda and content for today's presentation.
Come on, thank you very much Livia. I appreciate the introduction. Welcome everybody. Good. to get an idea of who they were talking to and it's always good to know where everyone is from so from what I'm hearing it seems like we have a lot of people who are dedicated to doing credit analysis, maybe some lenders who are at least looking at the result of the credit analysis, they potentially often do their own internal analysis and then in terms of experience level, it seems like we have a lot of people in the middle phase, so what we will do is really try to adapt this.
For everyone, even most, so I'm definitely going to talk basics about credit analysis, but then we'll also try to make apps that really help you get to a more intermediate level. Well, with that said, today's agenda is what we are going to do. What to talk about today is really the key fundamentals of successful loan packages as they go to the loan committee, in particular three areas, first the qualification phase, second the quantification and third the presentation, so if we think about what they mean, we're really talking about. You know how to qualify the client and also what they have to offer, quantify their ability to repay the debt and then finally put it into a presentable format.
It really helps not only make it clear to the loan committee but, more importantly, to you, the cards in the room. help those deals happen, so just as a quick introduction, let's talk a little bit about what a typical scenario is when you do your credit analysis from your perspective as I talk, I've talked to you, you know? hundreds of institutions across the United States, these are the three types of questions that seem to resurface every time someone discusses the solvency of a relationship. The first question is really who is borrowing the money, so who is the customer, what are they asking and why?
If they ask, number two would be: can you pay us fairly easily? Do they have enough cash flow to pay that debt? Step 3, ultimately we don't really want to get there, but we are protected when things go wrong, of course. We all know that good loans go bad from time to time, so what are we going to do to make sure our institution is covered? If we really start with credit theory and credit analysis, we'll be thinking about the five rates and The five C's of credit analysis really drive all of the decision making that we ultimately make when we're looking at the creditworthiness of an individual in a company or an overall relationship.
Most of this is probably review for most of you, but I just want to go over the five. seat, the number one character and you can't really put a quantifiable number to this, but the character or the personal integrity of the owners and the officers and the company is really irreplaceable, irreplaceable, you can't do business with business owners that They do not do it. actually have a stake in the loan, but also those that don't have integrity for sure, the second is capacity, certainly something that we'll spend a good amount of time looking at today and that ultimately generate enough cash to pay off that debt. . capital, so they are capitalized, especially compared to their industry peers, to cover any unexpected losses because it is a guarantee, so again, what happens if they can't pay?
Is there an alternative source of payment and the one that is often overlooked is the conditions and that is something that is really critical as it is important to understand the economic factors that come into play as well as the specific industries because each industry within The overall economy, of course, will react differently to the market environment, so when we think about the so what of these five rates, what is it about the five rates that we really need to understand to perform effective and efficient credit analysis? Number one is, of course, these five Cs require you to think through them.
You have to be able to quantify the results, but more importantly we also have to be able to present them to get approval and presenting the five C's is really critical to make sure it's a clear presentation of the risk that comes with this, of course, we deal in terms of numbers but also in terms of risk and so it's really critical for us to be able to look at these five fees and put them into a concise package where we can ultimately be successful in getting loans approved, so with that introduction and we can't choose a topic, let's transition.
For each individual point, the first one is the qualification section, so when we think about qualification, we are really thinking about the needs of our customer, who they are and what we have to offer, so the first question we really we must do. The answer about relationship is who our customer is for many of us on the line, whether it's a small community bank or a credit union. We're actually dealing with smaller companies in general, we're not dealing with the Microsofts of the world. We are not dealing with multinational global corporations, most of our clients tend to be small business owners and as we all have experience with these small business owners, many times they have big dreams, they know what they want to achieve. the idea is that people, but on the financial side maybe not as strong, sometimes they have difficulty executing, in particular, their financial statements and managing their financial statements.
You know, when I talk to business owners across the country, I often hear them ask me things like, you know? Why is the current ratio important or what is it? Even me, let's get down to the basics. What is EBIT? o I don't even understand this. What is a balance sheet? The variety of the knowledge base is really incredible as far as a lot of small business owners are concerned so those are the types of people that come to us for loans in a typical scenario of course we have the owners from smart companies who got their MBA or have a degree in accounting, but for the most part we are dealing with people who have the big idea is who knows the business but doesn't know the financial aspect, so the question arises: what is the problem?
I mean, they know how to run their business. He writes in a Michael Ames book on small business management. It is interesting that it lists the main reasons why companies encounter difficulties in terms of their cash flow and performance. You'll notice that the ones I've highlighted here, two, five, six and eight, really revolve around the financial aspect of your business, whether it's insufficient capital rather thanInvest in grips and fixings. assets from poor credit agreements or some kind of unexpected growth that affects your income statement and your balance sheet, so when we start to think about who they were looking at, we really have to keep in mind that the financial side of your business is really the struggle more difficult.
Many of them understand how to effectively run their business and of course a lack of experience in that area is a red flag, but a big red flag is often their actual financial performance, which brings us now to the last part. Whose client is it: why? need the loan, what is it about your business that makes it imperative for them to obtain some type of access to capital? So as we think about that, there's really a variety of different reasons from a general perspective, you know, are you a startup? They're just in growth mode where they're really looking to take it to the next level or there's some kind of change ahead, for example, they're doing succession planning, someone's looking to buy their business, what's really driving this need?
Maybe they simply need working capital, all that being said, it's critical to understand what drives your business needs and of course, as we delve into a little more detail, we need to think about what specific purchases are for real estate. They are for equipment, they are for inventory, etc. Ultimately, the needs of a real estate loan will be radically different and the analysis done there will also change. So imagine that if you are making some type of commercial real estate loan, of course it is important and the examiners will ask for an overall cash analysis, but it is also critical to understand whether that specific property will generate cash flow on its own if, for example, that property does not generate cash flow on its own, it really begs the question: if we consider this as a loan with our institution, the level of risk , of course, increases substantially if, on the other hand, it is about purchasing equipment for a typical CNI.
Lending, the analysis will look quite different than it might look more: is this business model sustainable in the future? Is it projected to continue to have sustained growth and cash flow more than today but in the next 2 or 3 years? Let's start thinking about these things, we are really starting to build a profile around the customer and who they are, that is, we are starting to qualify the needs as they come to us, of course, this is where we take a step in our work, and then we provide enough Capital for the right type of loan to the right person.
This is where you are really the experts. They know what types of loans are available, of course, especially if you have been a lender or are currently a lender. You should be quite familiar with them. all products within your institution, but just when we think about these, you know that there are a variety of different types of products available within your institution that may really better fit the needs of that particular company. For example, I was working with an institution this week with some training. and consulting work and were initially evaluating a traditional long-term loan; However, when they started looking at the business and its creditworthiness, they realized that an SBA loan might be a better approach, and of course, if it's a 504 or 7a, it's really critical.
Fars SBA When lending, it is critical to know which products internally will most effectively fit the needs of this particular business owner, so you really know how to deal with many of the more intangible aspects of credit analysis, but not all of them. they can be ignored without understanding who the customer is. is what are their needs and what do we have to satisfy, it is almost impossible to understand the next phase, which will be quantification, so if we think about that kind of summary, what is qualification? Well, scoring is really taking a problem and comparing it to a solution and that's really what we're doing in the world of credit analysis, we're looking at various problems, some kind of business problem and finding an appropriate solution, okay, now let's do a little transition and let's think more about practice. quantifiable section so we talked a lot about the qualitative position now let's think about the quantifiable position for business credit analysis of course the first part is the financial statement we're just going to do a summary because many of us have said that we are kind of Intermediate level in terms of our experience in credit analysis, so we're not going to spend too much time on what a financial statement is and hopefully provide more applications on how it will be meaningful, but to start, let's think about what a financial state.
It's just so we're all on the same page. A financial statement is simply a standard way of measuring and tracking performance and many times, when we deal with numbers day in and day out, we forget the big picture, we forget that it's real. The purpose of all of this is to track performance over time and say, wait a second, what's going to happen two years from now, five years from now, ultimately over the life of the loan, in a small business that will be able to handle. Debt service over time now the best way we can evaluate it is by looking at the past, so of course we start with the income statement, which is a measure of performance over a defined period of time.
We should also look at the balance sheet. which is the measure of performance at a discrete moment in time or a snapshot in time, ultimately we are using these two parts of a financial statement to build a holistic cash flow where we can measure changes on a balance sheet and an income statement in order. to see how that's affecting their cash position now again, that's our historical look at a particular business, actually what we really want to know is what that's going to be in the future. I wish we all had a magic 8 ball that could say it.
For us, this is approved, this is not approved, but then we would all be out of work, so the good news is that credit analysis is not just science, it is not just calculating some ratios, it is also art, it really requires a lot of interpretation and for those. Many of you who have been in the field for a while really know that there is a lot of analysis involved beyond just calculating a few key ratios, we need to be able to take historical performance and then evaluate it and see what it will look like in the likely future.
Going forward scenario that being said, the first thing we're going to want to do is of course look at your key metrics, it's not enough to just look at your cash flow as to whether it's there to calculate or work changes. capital, it's really critical for us to look at a variety of key ratios that really help us evaluate the performance and risk of this particular ratio, so when we think about an example, we have a current ratio, so the ratio circulating is nothing more than a measure. Whether a company has sufficient resources to pay its short-term debt over the next 12 months is essentially a way to evaluate its working capital needs and the performance of its working capital.
Now, the current ratio is a great example of one that is often overlooked, it is something that can sometimes be scanned and evaluated quickly, but without really thinking about what this means for performance over time. If, for example, a company has a poor current ratio, it really indicates that they mean they can generate long-term cash flow for a while. particular loan, but do they have enough cash right now to pay their bills when they are due? That's a really critical metric for understanding tracking and ultimately projecting into the future. That's an example. There are a lot of ratios, whether we're talking. days of accounts receivable or days of inventory or whether we're talking about gross profit margin, these are all drivers of cash flow and they're really essential to understanding whether this is a healthy company now and will continue to be healthy in the future.
That said, of course working capital and actual dollar values are critical, a couple of other key points we all think about are things like EBIT, sure, sounds daunting to most of you, you're probably an expert on what it is and what it isn't, but for those of us who are on the call and who know, this can be a first kind of dive into credit analysis, including earnings before taxes, depreciation and amortization, and if we really think conceptually about what this means and why it is net critical. income, that is, the bottom line on a company's income statement is not actually the cash available to pay debt;
There are a variety of non-cash expenses as well as other factors that we must add to properly evaluate your cash flow, which is why we have the additional interest, taxes, depreciation and amortization accounts. The other complicated thing that requires a lot of interpretation is that each institution can choose to calculate this slightly differently and we see this on Wall Street all the time, including when earnings reports are released. Publicly traded companies sometimes use a unique way of calculating EBIT, although we'll put it that way, sometimes that beef can mean they add certain expenses that actually make their position look much stronger than it actually is.
That said, this is why it's really critical to understand EBIT and its importance in what the business can deliver, so for example some institutions will use EBIT as traditional EBITDA, some institutions I work with will use it. without the T, that is, taking out taxes, the reason why they should hypothetically pay, you know our loan, but in reality, either they will not pay a loan or they will not pay taxes, which one takes priority, many institutions will accept it, you know which will not be added again. EBIT the t and still, that being said for many small business owners, it's not really that critical anyway, if they are an S corporation or an art business, the taxes will flow through the people, follow them through the business anyway, another The calculation method that Eva often does after the dividends have been paid again, in theory, they will pay off their loans before paying the shareholders or partners;
However, especially as you know, from a risk management perspective, many institutions will actually choose to use even after dividends to come up with a more conservative approach, so of course the last one we can use is the net cash after operations and that will not only include the income statement but also the balance sheet, so we will see changes in working capital to achieve a true cash position on both the income statement and the balance sheet, so, Why did I spend all that time talking about this? At the end of the day, there are a lot of gray areas, there are a lot of institutions out there, we do things slightly differently and each examiner may have slight differences in their approach, so it's really critical that each institution puts together really good policies around this to have consistency. and therefore reliability in your credit analysis and ultimately that brings us to ratio.
Like the debt service coverage ratio, ultimately the individual can pay off that debt and is there a little bit of buffer space? Of course, a 1.0 just means how absolutely they can pay off their debt each year. A 1.2 1.25 is generally what I see as best practice. That said, the country, of course, gives us a little bit of leeway and really decreases some of our risk in that relationship. Hopefully that gives us a good idea of some of the key metrics and why they are critical to getting it right. Why they are essential. think about our policies around them and really nail them down to have consistency within our credit process, the next part of the quantification that we want to talk about here is the industry comparison and this is really critical, especially when you're talking about ratios key, but With cash flow in general, we need to think about how they are doing compared to their peers, what they are doing now, what they have done historically and then what kind of key metrics we want to look at to evaluate this so that with the Key Metrics In general, there are a variety of different key metrics you could think of, maybe sales growth, maybe current ratio, maybe net profit margin, maybe even company service coverage. debt, there are a variety of different key metrics that we really need to think about and of course analyzed relative to its peers, so for example maybe we look at our current index, in this case we see that a company is in the blue , the dark blue columns and the industry in light blue or teal, which really gives us thefeeling okay, then your current index was real.
It's pretty poor compared to the industry in the past in 2010, but the good news is that the trend has been going up, so this particular business is increasing its working capital and its ability to pay its current obligations, but Even so, there is still a little bit more bass. than the rest of their industry, so they're currently at 1.77, but the industry is at 2.15 over the same period, so it's really helpful to do this type of analysis to say no, maybe they're doing better than they were, but they are still not where they should be if we look at them in the industry, another example would be that profit margin, so we see again that the trend is going in the positive direction, but in this case they actually is doing better than its peers, so while they were doing substantially worse in the past, if we look at their current net profit margin, it's seven point zero three percent, while the industry is only four point one two, so this really shows us that in this case their net profit is strong compared to the industry, but their current ratio is a little bit weak, so we can see that they are providing enough cash flow, but their capital work may need to reinforce some of the management of your accounts receivable or payable, your inventory, etc., so these are some of the facets we should think about in quantifying credit analysis.
We talked a little bit about the financial statements. Some of the key metrics as well as industry comparisons. Now, all of this is really what we traditionally think of as credit analysis. Many times we do not think about qualification because they are rather intangible and we specifically think only about quantification, but both go hand in hand, they cannot go without each other, it is really essential to know who the customer is. It's why they need the loan and they can also pay off the debt, which begs the question is what's the rest of the webinar on why go further and that's probably the one I see constantly that isn't really considered true credit. analysis of the institutions and yet the institution has solid credit policies, this is absolutely fundamental to the loan package and that is the presentation, so the institutions that I have worked with that really have a solid credit department, the Presentation is absolutely well thought out with good policies.
Imagine going to the loan committee and you have a 50 page spreadsheet that you have put together about an overall cash flow of a particular relationship along with personal information along with collateral along with all the different elements that you currently show to the loan committee and point out that against the loan committee, but What I have seen consistently is that a lot of times this becomes quite overwhelming, so they just look at the main page, they don't go into the details, they really rely a lot on you for that information, plus when You have so much information.
Documentation takes a lot of time and effort to turn into a presentable view, so a typical process I often see within credit departments is a variety of formats, whether PDF, Microsoft Excel, Microsoft Word, or a host of other formats. copy and paste and there is a lot of manual labor involved in putting together that package for the loan committee. Also, what I often see is really one area that can make credit analysis challenging to get approved for those loans, is an overabundance of information, so if that's a treacherous area that we spend a lot on At the same time, we are providing too much information that ultimately the loan committee simply reverts to a subjective decision-making process.
What does a successful loan package look like? And this is something where I've seen, a lot of institutions have really transitioned their loan presentation to be much more successful on the loan committee. A couple of key elements to this is thinking about why that really helps us understand and what we need to be able to tell the story effectively, which requires a narrative, requires writing this report to the point, but it effectively tells the loan committee what is the scenario, who is the borrower, our borrowers, what type of guarantor is their relationship with the type of guarantee, etc., etc.
All of that, of course, should be in a fairly condensed and easy-to-follow article; Secondly, we need to think about the what and that really needs to be the highlight, one of the later areas where I see obstacles within credit. The world is putting every bit of information out of every financial statement, that is, the balance sheet of the income statement. You see cash flow, everything works, and that's all included in the loan presentation, when in reality the loan committee really only needs to see one key high-level metric. or a prominent key focus, ultimately the packages I see that are successful tend to be the principle that less is more.
What does it really look like? How do we get to that final state? If less is more. What is a process we can use internally? To get there, the processes that I see that are really effective in getting to that place is to start with the full analysis. Really look in depth at all the differentials. Look at all key metrics. Look at industry comparisons. Look at the warranty. look at all the different factors that go into this particular loan, but don't stop there, make sure you step back and synthesize, say what are the things that I would like to know about that you were making the decision about this loan. and then ultimately make it as concise as possible so that the institutions where I see this happening consistently actually have a much more efficient and effective loan packaging process and ultimately get more business, which in turn Of course, it gives us more opportunities for the bank to grow in a variety of areas, so just as a quick demonstration, I'm just going to show a couple of things that can help as we start to think about qualification, quantification and presentation.
For example, you'll notice that I have an Excel document. here with key high level metrics now I have a variety of different margins for companies and for individuals and for real estate and collateral, but I actually care about these key high level metrics and that's because that's what the loan committee Although I have all the necessary details, it is really essential to distill them into the most important real high-level metrics to help us pay attention to that particular credit, for example, the debt service coverage ratio, and you will notice that I have not done it. divided into real estate, business, personal and global, it really helps the loan committee make a decision based on whether it is a commercial real estate loan or a CNI loan;
Otherwise, the loan committee knows that this is exactly what we are looking at. We're seeing real estate cash flow as well, the person has this type of cash flow in the business as this type of cash flow, but ultimately also what is the big picture in the big picture analysis, that being said In reality, successful presentations I've seen often take a high-level approach, so here's an example I've made anonymous from an institution. here. I will note that you have a loan structure and the approval you have for the borrower is for the guarantor Zar very direct, very direct, there is not a lot of detail, but it provides critical information, it really tells the sowhat from the beginning what they are asking for e.g. the terms of the loan, why are they applying for it, who is applying for it and then yes or no with any additional comments and of course it all fits on one page.
It's really a conclusion at the beginning as I scroll down through this word. document, you'll notice that all of those key metrics are synthesized and put back on one page where we now have all of the key cash flow metrics as well as the collateral metrics as well as the risk score, allowing us to provide a summary of a page. of the entire relationship with just a few key metrics that really help us in the loan committee process now, of course, you may have supporting information as you review the rest of the spreads, but really put the bottom line at the front right here, at the same moment. at the beginning of your loan presentation having said that, of course, by doing all the hard work with the scoring, all the scientific part, the quantification and then the artistic part of putting that into a meaningful presentation, it helps us give us, hopefully , many more approvals. stamped on those pages, so in summary, we talked a little bit about how to qualify customers' needs, who they are, and what we have to offer.
We've talked about some quantification best practices, as well as maybe some additional analysis that goes into there and So, ultimately, what are we going to do to present this in the most effective way possible? Hopefully that gave us a good idea of credit analysis at the 101 level. Thanks everyone. What we're going to do, of course, is open this up for questions in just a moment. I think Libby has one more final question before we transition and open the session to QA. Thanks Peter, we have one question left from the survey. This is a quick question as we ask if you want.
Go ahead and start entering any questions that may have come up during the session. You can do this using the chat or questions feature within the program, but I'm just going to throw out a quick question about the staged credit analysis that we've tried. keep this presentation very focused on the content, but if you are or if you're interested in taking a look, if you want to learn more, we encourage you to go ahead and select the answer here that might be most appropriate and we'll give it to you. Just a moment, the question is: I would like to see a personalized credit analysis to see how it can help our institution streamline and improve credit decisions.
It seems that most of you had the opportunity to vote. I'll give you just One more moment, you may also be thinking about those questions that you're going to send to Peter in a moment, but they're still coming in, so give us a moment and it looks like we have most of the questions. questions I'm going to go ahead and close that and now we're going to open it up for additional questions from the audience and we've had several that have come in throughout the session, the first of which is Peter, what are some? rules of thumb when trying to determine which entity should be incorporated into your overall cash flow, great question, thanks for that question, I hope this all benefits everyone too, so if you know, I understand the question when we are evaluating our analysis global here.
With the cash flow, are we considering guarantor one and business one, or are we including business two, three, four, five, six, and three other individuals? Of course, that's a great question. I think the general rule is that if there is cash flow coming in or cash flow going out, it should be included in that overall cash flow analysis, so, for example, it is recurring and regular in a cash flow. So, for example, let's say we have in two individuals John Smith and Sally Jones, and John Smith is the guarantor of this relationship and he is the owner of Construction LLC, they are a small construction company, but he also has Sally Jones, who is a partner in their business endeavors.
Sally or not owns, you know, one hundred percent of the visit. Sorry, 50 percent, she owns about 25 percent of the business while mr. Smith owns about 50 percent of the business, so whether we should actually include Sally in that overall cash flow or not, the question is if the business starts to do poorly, who can contribute cash to that business? Who can help keep it afloat? When we think about small businesses, the owners of the business are integral to the cash flow, it is very difficult to separate the owner(s) of a small business from the cash flow of the business, for example very low wages are often paid, but then they will distribute almost all the cash at the end of the year among themselves, so to truly effectively analyze the risk of this relationship, we are going to want to analyze Sally, as well as John, as well as the business the way we we know. that Sally will in fact have enough cash flow, she's not up to her eyes in debt and she can't help pay down that debt whether she's a guarantor or not because ultimately her cash and the cash flow of the business are going to be very difficult to separate, so that's on the guarantor side, now on the business side, let's add one more unique situation.
Suppose Sally also owns another business, so Sally and John owned a business together which is the construction company, butSally also owns a restaurant. The question is whether that restaurant should be included. this relationship when, in particular, the loan is given to the construction company, well, of course, again, it is best practice with many of these small business owners, Sally is one hundred percent owner of this restaurant, where does Can that money really come? other business endeavors, so you may be taking a lot of cash out of the construction company to meet any of your needs in the restaurant, so to get the big picture, a ridiculous perspective, we want to see all the entities that are going to If we have significant recurring cash flow in either direction, that never negates the need to look at the individual borrower, in this case the business, the construction company, we should still put our primary emphasis on their ability to repay the debt, but if we look globally, we need to include all entities that have a substantial portion of cash flow, so I know that was a long answer, I hope it makes a lot more sense as we look at it.
A very good question. Other questions at this point. Libby, next question. What we have is when we consider a financial analysis on historical earnings, where we are more likely to see non-recurring income and how we can create a safety net and a credit analysis that is non-recurring. I'm sorry to be aware of non-recurring versus recurring revenue stream is a big question, so as I understand it the question is really everywhere, I know how we know it's regular, reliable revenue, so it's A good business question with an easy answer on the business side, generally speaking what you want to discuss. at least three years of business performance within Sageworks, you can use our projection tool to then do a regression analysis, it automates that for you and you can see if they are likely to continue those revenue streams in the future, that's the easy answer so far. as businesses, it's pretty simple, you know, to look at your revenue streams, break it down into stages, project it forward using the projection tool and say what's likely to continue as far as trends now on the personal side, it's more about of some kind of configuration. good policies, for example line 13 on form 1040 is capital gain or loss, it's really critical to know if it's regular and reliable, so that's an example of one that you'll want to look at probably at least three years, but in this case, you will have to tell the artistic part of the credit analysis and the interpretation part, you, as the analysts, will have to say: Does this person move houses to earn a living?
That's why 13 capital gains are a substantial and recurring part of your income; On the other hand, if it is someone who owns a software company, capital gains or losses should not be regular and reliable, generally, unless of course they own another business on the side, so That's really where you as the analyst have to start thinking about the details and establish some policies that will help you be consistent in the future, so line 13 is a good example. Some other examples would be interpreting the schedule part, or the k-1 schedule; others could be trusts. in schedule state revenue' part 3, etc., so hopefully those are some examples of things that you might want to think about and establish some consistent policy around those particular items.
Well, it looks like we had a follow-up. The question that arose was, if non-recurring income from overall cash flow, such as capital gains, is omitted from a personal tax return, are adjustments made for income taxes paid? ? Good question, absolutely, you would like to make an adjustment to the income taxes paid. Again, at your discretion, whether that is regular and recurring or rather non-regular and recurring. Well done! Excellent. Another question we received was how would you compare business finance to others in the industry? A great question, so one of the best ways is to find a data source that will give you reliable data from private companies.
Private company data is quite difficult to get, of course, we can all compare our businesses to Microsoft if it is a software company, but most of the companies we lend to are probably the size of Microsoft, so we really want get a data source from a private company, there are a variety of sources available, one or two pages, actually, such as the largest real-time database of private companies. Obviously, I'm not biased, but I highly recommend it. our data source here, where our data is coming from, is financial professionals, so we're getting really clean data, it's not coming from self-reports or tax returns primarily, it's coming primarily from financial statements, so that's a good one. way to do it, of course.
You can always use a publicly traded company, but I highly recommend looking at averages for private companies and then another question we have has to do with marital income. Is marital income typically omitted from cash flow for non-guarantor spouses or? Do you have ownership in the business, a great question I get asked quite often. I would say the best practice that I see most regularly in the industry is to evaluate husband and wife or wife and husband depending on the direction together and here is why a marriage relationship for those of us who are married probably I would say the same it is a unique relationship unlike any other business relationship, if for example I were married or if my wife cannot pay bills, who will she turn to me?
On the other hand, if she can't pay her bills, who will she turn to me? So when we think about a good cash flow and risk assessment, we really want to bring that spouse in, even if we're not guarantors on the loan because it's really hard to separate the spouse's income, not just because they often file taxes. as jointly married, but also because you know at the end of the day they really do act as a unit, so hopefully that's how it will be. useful best practices, very good, excellent, and we have several other questions that have come up that we probably won't address during today's session, but one more question that we will conclude with is when should you need a business guarantor that is not the borrowing entity the that guarantees the loan, so the question here, of course, is when looking at other companies, not just the one that is applying for the loan, when should we guarantee them.
I would say that best practice is generally when ownership is a substantial part. Now I know that sounds like a gray area. It is if, for example, the guarantor of a business, the main business here, the main borrower, if that owner is also between twenty-five percent or 75 percent. percent as minimum ownership in another entity that is a good candidate to be a guarantor, certainly, if they own 50 percent or more, it's more or less, I would say consistent as a standard, you would want to use them as a guarantor like these again. Small business owners will transfer cash from one entity to another if they own more than 50 percent, and they will do so fairly consistently.
So that's a good question and thank you very much for anything else we can get right now, Libby. or we know I think we're out of time for the day, but we have several other questions that have come in so you can check your email this afternoon or early tomorrow morning. We'll answer them individually, but otherwise, I really appreciate everyone for taking the time to join us this afternoon and Peter, thank you also for sharing your great ideas on credit analysis. We'll also be sharing the slides, so we recorded this afternoon via email and we'll keep an eye on that as well, but in the meantime, if you have any questions or concerns about the stage work, please feel free to contact us.
Our website is the job analyst page for our banking institutions and there are phone numbers and emails you can use to communicate, as well as some of those additional reasons versus the ones we tried Shawn include some whitepaper templates and recorded webinars which were only posted previously, so thanks again for taking the time. We hope to see you again soon at our next webinar.
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